BORROWING FROM PETER TO PAY PAUL: THE WALL STREET PONZI SCHEME CALLED FRACTIONAL RESERVE BANKING

http://www.webofdebt.com/articles/ponzi.php

BORROWING FROM PETER TO PAY PAUL:
THE WALL STREET PONZI SCHEME CALLED FRACTIONAL RESERVE BANKING
Ellen Brown, December 29th, 2008
www.webofdebt.com/articles/ponzi.php


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Cartoon in the New Yorker:
A gun-toting man with large dark glasses, large hat pulled down,
stands in front of a bank teller, who is reading a demand note. It
says, “Give me all the money in my account.”

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 trillion
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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Kathleen Pender, “Government Bailout Hits $8.5 Trillion,” San
Francisco Chronicle (November 26, 2008).

“Federal Reserve Statistical Release H.6, Money Stock Measures,”
www.federalreserve.gov (December 18, 2008).

Robert de Fremery, “Arguments Are Fallacious for World Central Bank,”
The Commercial and Financial Chronicle (September 26, 1963), citing E.
Groseclose, Money: The Human Conflict, pages 178-79.

Robert Owen, The Federal Reserve Act (1919); “Who Was Philander
Knox?”, www.worldnewsstand.net/history/PhilanderKnox.htm. (1999).

Ron Morrison, “Keynes Without Debt,” www.prosperityuk.com/prosperity/articles/keynes.html
(April 2004).

Martin Weiss, “Biggest Sea Change of Our Lifetime,” Money and Markets
(December 22, 2008).

Martin Wolf, “‘Helicopter Ben’ Confronts the Challenge of a Lifetime,”
Financial Times (December 16, 2008).
.