Borrowing from Peter to Pay Paul: The Wall Street Ponzi Scheme Called Fractional Reserve Banking
Arizona Coin Collector
http://www.opednews.com/articles/Borrowing-from-Peter-to-Pa-by-Ellen-Brown-081229-255.html
Borrowing from Peter to Pay Paul: The Wall Street Ponzi Scheme Called
Fractional Reserve Banking
by Ellen Brown
December 29, 2008 at 15:35:26
Bernie Madoff showed us how it was done: you induce many
investors to invest their money, promising steady
above-market returns; and you deliver - at least on paper.
When your clients check their accounts, they see that
their investments have indeed increased by the promised
amount. Anyone who opts to pull out of the game is paid
promptly and in full. You can afford to pay because most
players stay in, and new players are constantly coming
in to replace those who drop out. The players who drop
out are simply paid with the money coming in from new
recruits. The scheme works until the market turns and
many players want their money back at once. Then it's
game over: you have to admit that you don't have the
funds, and you are probably looking at jail time.
A Ponzi scheme is a form of pyramid scheme in which earlier
investors are paid with the money of later investors rather
than from real profits. The perpetuation of the scheme
requires an ever-increasing flow of money from investors
in order to keep it going. Charles Ponzi was an engaging
Boston ex-convict who defrauded investors out of $6 million
in the 1920s by promising them a 400 percent return on
redeemed postal reply coupons. When he finally could not
pay, the scam earned him ten years in jail; and Bernie
Madoff is likely to wind up there as well.
Most people are not involved in illegal Ponzi schemes,
but we do keep our money in accounts that are tallied on
computer screens rather than in stacks of coins or paper
bills. How do we know that when we demand our money from
our bank or broker that the funds will be there? The fact
that banks are subject to "runs" (recall Northern Rock,
Indymac and Washington Mutual) suggests that all may not
be as it seems on our online screens. Banks themselves
are involved in a sort of Ponzi scheme, one that has
been perpetuated for hundreds of years. What
distinguishes the legal scheme known as "fractional
reserve" lending from the illegal schemes of Bernie
Madoff and his ilk is that the bankers' scheme is
protected by government charter and backstopped with
government funds. At last count, the Federal Reserve
and the U.S. Treasury had committed $8.5 trillion to
bailing out the banks from their follies.1 By
comparison, M2, the largest measure of the money
supply now reported by the Federal Reserve, was just
under $8 trilion in December 2008.2 The sheer size of
the bailout efforts indicates that the banking scheme
has reached its mathematical limits and needs to be
superseded by something more sustainable.
Penetrating the Bankers' Ponzi Scheme
What fractional reserve lending is and how it works
is summed up in Wikipedia as follows:
"Fractional-reserve banking is the banking practice
in which banks keep only a fraction of their
deposits in reserve (as cash and other liquid
assets) with the choice of lending out the
remainder, while maintaining the simultaneous
obligation to redeem all deposits immediately upon
demand. This practice is universal in modern
banking. . . .The nature of fractional-reserve
banking is that there is only a fraction of cash
reserves available at the bank needed to repay all
of the demand deposits and banknotes
issued. . . . When Fractional-reserve banking
works, it works because:
"1. Over any typical period of time, redemption
demands are largely or wholly offset by new
deposits or issues of notes. The bank thus needs
only to satisfy the excess amount of redemptions.
"2. Only a minority of people will actually choose
to withdraw their demand deposits or present their
notes for payment at any given time.
"3. People usually keep their funds in the bank
for a prolonged period of time.
"4. There are usually enough cash reserves in the
bank to handle net redemptions.
"If the net redemption demands are unusually large,
the bank will run low on reserves and will be
forced to raise new funds from additional borrowings
(e.g. by borrowing from the money market or using
lines of credit held with other banks), and/or sell
assets, to avoid running out of reserves and
defaulting on its obligations. If creditors are
afraid that the bank is running out of cash, they
have an incentive to redeem their deposits as soon
as possible, triggering a bank run."
Like in other Ponzi schemes, bank runs result
because the bank does not actually have the funds
necessary to meet all its obligations. Peter's
money has been lent to Paul, with the interest
income going to the bank. As Elgin Groseclose,
Director of the Institute for International Monetary
Research, wryly observed in 1934:
"A warehouseman, taking goods deposited with him
and devoting them to his own profit, either by use
or by loan to another, is guilty of a tort, a
conversion of goods for which he is liable in civil,
if not in criminal, law. By a casuistry which is
now elevated into an economic principle, but which
has no defenders outside the realm of banking, a
warehouseman who deals in money is subject to a
diviner law: the banker is free to use for his
private interest and profit the money left in
trust. . . . He may even go further. He may create
fictitious deposits on his books, which shall rank
equally and ratably with actual deposits in any
division of assets in case of liquidation."3
How did the perpetrators of this scheme come to
acquire government protection for what might
otherwise have landed them in jail? A short history
of the evolution of modern-day banking may be
instructive.
The Evolution of a Government-Sanctioned Ponzi Scheme
What came to be known as fractional reserve lending
dates back to the seventeenth century, when trade
was conducted primarily in gold and silver coins.
How it evolved was described by the Chicago Federal
Reserve in a revealing booklet called "Modern Money
Mechanics" like this:
"It started with goldsmiths. As early bankers, they
initially provided safekeeping services, making a
profit from vault storage fees for gold and coins
deposited with them. People would redeem their
"deposit receipts" whenever they needed gold or
coins to purchase something, and physically take
the gold or coins to the seller who, in turn, would
deposit them for safekeeping, often with the same
banker. Everyone soon found that it was a lot easier
simply to use the deposit receipts directly as a
means of payment. These receipts, which became known
as notes, were acceptable as money since whoever
held them could go to the banker and exchange them
for metallic money.
"Then, bankers discovered that they could make loans
merely by giving their promises to pay, or bank
notes, to borrowers. In this way, banks began to
create money. More notes could be issued than the
gold and coin on hand because only a portion of the
notes outstanding would be presented for payment at
any one time. Enough metallic money had to be kept
on hand, of course, to redeem whatever volume of
notes was presented for payment.
"Transaction deposits are the modern counterpart of
bank notes. It was a small step from printing notes
to making book entries crediting deposits of
borrowers, which the borrowers in turn could 'spend'
by writing checks, thereby 'printing' their own money."
If a landlord had rented the same house to five people
at one time and pocketed the money, he would quickly
have been jailed for fraud. But the bankers had devised
a system in which they traded, not things of value, but
paper receipts for them. It was called "fractional
reserve" lending because the gold held in reserve was a
mere fraction of the banknotes it supported. The scheme
worked as long as only a few people came for their gold
at one time; but investors would periodically get
suspicious and all demand their gold back at once. There
would then be a run on the bank and it would have to
close its doors. This cycle of booms and busts went on
throughout the nineteenth century, culminating in a
particularly bad bank panic in 1907. The public became
convinced that the country needed a central banking
system to stop future panics, overcoming strong
congressional opposition to any bill allowing the
nation's money to be issued by a private central bank
controlled by Wall Street. The Federal Reserve Act
creating such a "bankers' bank" was passed in 1913.
Robert Owens, a co-author of the Act, later testified
before Congress that the banking industry had
conspired to create a series of financial panics in
order to rouse the people to demand "reforms" that
served the interests of the financiers.4
Despite this powerful official backstop, however, the
greatest bank run in history occurred only twenty
years later, in 1933. President Roosevelt then took
the dollar off the gold standard domestically, and
Federal Reserve officials resolved to prevent further
bank runs after that by flooding the banking system
with "liquidity" (money created as debt to banks)
whenever the banking Ponzi scheme came up short.
"Too Big to Fail": The Government Provides the
Ultimate Backstop
When these steps too proved insufficient to keep
the banking scheme going, the government itself
stepped up to the plate, providing bailout money
directly from the taxpayers. The concept that
some banks were "too big to fail" came in at the
end of the 1980s, when the Savings and Loans
collapsed and Citibank lost 50 percent of its
share price. Negotiations were conducted behind
closed doors, and "too big to fail" became standard
policy. Bank risk was effectively
nationalized: banks were now protected by the
government from loss regardless of risk-taking or
bad management.
There are limits, however, to the amount of support
even the government's deep pocket can provide. In
the past two decades, the bankers' lending scheme
has been kept going by an even more speculative
scheme known as "derivatives." This is a complex
subject that has been explored in other articles,
but the bottom line is that more dollars are now
owed in the derivatives casino than exist on the
planet. (See Ellen Brown, "It's the Derivatives,
Stupid!" and "Credit Default Swaps: Derivative
Disaster Du Jour," www.webofdebt.com/articles.)
Attempting to fill the derivatives black hole with
taxpayer money must inevitably be at the expense
of other essential programs, such as Social
Security and Medicare.
Interestingly, Social Security and Medicare themselves
are in some sense Ponzi schemes, since earlier
retirees collect their benefits from the contributions
of later workers. These programs, too, may soon be
facing bankruptcy, in this case because their
mathematical models failed to account for a huge
wave of Baby Boomers who would linger longer than
previous generations and demand expensive drugs and
care through their senior years, and because the fund
money has have been drawn on by the government for
other purposes. The question here is, should the
government be backstopping private banks that have
mismanaged their investment portfolios at the expense
of workers contractually entitled to a decent
retirement from a fund they have paid into all their
working lives? The answer, of course, is no; but there
may be a way that the government could do both. If it
were to nationalize the banking system
completely - if the government were to assume not
just the banks' losses but their profits, oversight
and control - it might have the funds both to maintain
Social Security and Medicare and to provide a
sustainable credit mechanism for the whole economy.
Replacing Private with Public Credit
Readily available credit has made America "the land of
opportunity" ever since the days of the American
colonists. What has transformed this credit system
into a Ponzi scheme that must continually be propped
up with bailout money is that the credit power has
been turned over to private parties who always require
more money back than they create in the first place.
Benjamin Franklin reportedly explained this defect
in the eighteenth century. When the directors of the
Bank of England asked what was responsible for the
booming economy of the young colonies, Franklin
explained that the colonial governments issued their
own money, which they both lent and spent into the
economy:
"In the Colonies, we issue our own paper money. It is
called 'Colonial Scrip.' We issue it in proper
proportion to make the goods pass easily from the
producers to the consumers. In this manner, creating
ourselves our own paper money, we control its
purchasing power and we have no interest to pay to
no one. You see, a legitimate government can both
spend and lend money into circulation, while banks
can only lend significant amounts of their promissory
bank notes, for they can neither give away nor
spend but a tiny fraction of the money the people
need. Thus, when your bankers here in England place
money in circulation, there is always a debt
principal to be returned and usury to be paid. The
result is that you have always too little credit
in circulation to give the workers full employment.
You do not have too many workers, you have too
little money in circulation, and that which
circulates, all bears the endless burden of
unpayable debt and usury."
In an article titled "A Monetary System for the
New Millennium," Canadian money reform advocate
Roger Langrick explains his concept in contemporary
terms. He begins by illustrating the mathematical
impossibility inherent in a system of bank-created
money lent at interest:
"[I]magine the first bank which prints and lends out
$100. For its efforts it asks for the borrower to
return $110 in one year; that is it asks for 10%
interest. Unwittingly, or maybe wittingly, the bank
has created a mathematically impossible situation.
The only way in which the borrower can return 110
of the bank's notes is if the bank prints, and lends,
$10 more at 10% interest . . . . The result of
creating 100 and demanding 110 in return, is that
the collective borrowers of a nation are forever
chasing a phantom which can never be caught; the
mythical $10 that were never created. The debt in
fact is unrepayable. Each time $100 is created for
the nation, the nation's overall indebtedness to
the system is increased by $110. The only solution
at present is increased borrowing to cover the
principal plus the interest of what has been borrowed."
The better solution, says Langrick, is to allow the
government to issue enough new debt-free dollars
to cover the interest charges not created by the
banks as loans:
"Instead of taxes, government would be empowered to
create money for its own expenses up to the
balance of the debt shortfall. Thus, if the banking
industry created $100 in a year, the government
would create $10 which it would use for its own
expenses. Abraham Lincoln used this successfully
when he created $500 million of 'greenbacks' to
fight the Civil War."
National Credit from a Truly National Banking System
In Langrick's example, a private banking industry
pockets the interest, which must be replaced every
year by a 10 percent issue of new Greenbacks; but
there is another possibility. The loans could be
advanced by the government itself. The interest would
then return to the government and could be spent
back into the economy in a circular flow, without
the need to continually issue more money to cover
the interest shortfall.
The fractional reserve Ponzi scheme is bankrupt, and
the banks engaged in it, rather than being bailed out
by its victims, need to be put into a bankruptcy
reorganization under the FDIC. The FDIC then has the
recognized option of wiping their books clean and
taking the banks' stock in return for getting them
up and running again. This would make them truly
"national" banks, which could dispense "the full
faith and credit of the United States" as a public
utility. A truly national banking system could revive
the economy with the sort of money only governments
can issue - debt-free legal tender. The money would
be debt-free to the government, while for the private
sector, it would be freely available for borrowing
at a modest interest by qualified applicants. A
government-owned bank would not need to rob from
Peter to advance credit to Paul. "Credit" is just
an accounting tool - an advance against future
profits, or the "monetization" (turning into cash)
of the borrower's promise to repay. As British
commentator Ron Morrison observed in a provocative
2004 article titled "Keynes Without Debt":
"[Today] bank credit supplies virtually all our
everyday means of exchange, and this brings into
sharp focus the simple fact that modern money is
no longer constrained by outmoded intrinsic
values. It is pure fiat [enforced by law] and
simply a glorified accounting system. . . . Modern
monetary reform is about displacing the current
economic paradigm of 'what can be afforded' with
'what we have the capacity to undertake.'"5
The objection to government-issued money has
always been that it would be inflationary, but
today some "reflating" of the economy could be a
good thing. Just in the last year, more than $7
trillion in purchasing power has disappeared
from the money supply, including wealth
destruction in real estate, stocks, mutual fund
shares, life insurance and pension fund
reserves.6 Money is evaporating because old
loans are defaulting and new loans are not
being made to replace them.
Fortunately, as Martin Wolf noted in the December
16 Financial Times, "Curing deflation is child's
play in a 'fiat money' - a man-made money - system."
The central banks just need to get money flowing
into the economy again. Among other ways they
could do this, says Wolf, is that "they might
finance the government on any scale they think
necessary."7
Rather than throwing money at a failed private
banking system, public credit could be redirected
into infrastructure and other projects that would
get the wheels of production turning again. The
Ponzi scheme in which debt is just shuffled
around, borrowing from one player to pay another
without actually producing anything of real value,
could be replaced by a system in which the national
credit card became an engine for true productivity
and growth. Increased "demand" (money) would come
from earned wages and salaries that would increase
"supply" (goods and services) rather than merely
servicing a perpetually increasing debt. When
supply keeps up with demand, the money supply can
be increased without inflating prices. In this
way the paradigm of "what we can afford" could
indeed be superseded by "what we have the capacity
to undertake."
Ellen Brown developed her research skills as an
attorney practicing civil litigation in Los
Angeles. In Web of Debt, her latest book, she
turns those skills to an analysis of the Federal
Reserve and "the money trust." She shows how
this private cartel has usurped the power to
create money from the people themselves, and
how we the people can get it back. Her earlier
books focused on the pharmaceutical cartel that
gets its power from "the money trust." Her
eleven books include Forbidden Medicine, Nature's
Pharmacy (co-authored with Dr. Lynne Walker),
and The Key to Ultimate Health (co-authored
with Dr. Richard Hansen). Her websites are
www.webofdebt.com and www.ellenbrown.com .
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