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Borrowing from Peter to Pay Paul: The Wall Street Ponzi Scheme Called Fractional Reserve Banking

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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.

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Ellen Brown is an attorney, founder of the Public Banking Institute, and author of twelve books including the best-selling WEB OF DEBT. In THE PUBLIC BANK SOLUTION, her latest book, she explores successful public banking models historically and (more...)
 
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Good article, but some observations for Ellen: 1. ... by Kuzminski on Monday, Dec 29, 2008 at 5:36:45 PM
Thanks for writing.  The Federal Reserve Bank... by Ellen Brown on Monday, Dec 29, 2008 at 6:14:16 PM
Yes, the reserve requirement is essentially meanin... by Kuzminski on Monday, Dec 29, 2008 at 6:50:48 PM
I do not see the problem as being fractional reser... by pft on Monday, Dec 29, 2008 at 6:58:57 PM
Tell us how exactly a tether of gold imparted your... by mike montagne on Tuesday, Dec 30, 2008 at 2:50:30 PM
tell us who owns the Federal Reserve? If not, w... by hommedespoir on Wednesday, Dec 31, 2008 at 8:29:18 PM
They are owned by the commercial banks making up t... by pft on Thursday, Jan 1, 2009 at 1:13:59 AM
1. Fractional reserve banking need not be a ponzi ... by William Whitten on Tuesday, Dec 30, 2008 at 4:08:15 AM
Great article! The question is: Why isn't ther... by Jack Hughes on Monday, Dec 29, 2008 at 8:22:01 PM
"The question is: Why isn't there a US Na... by William Whitten on Tuesday, Dec 30, 2008 at 4:26:44 AM
Actually, see the Constitution. If you see our pag... by mike montagne on Tuesday, Dec 30, 2008 at 11:12:26 PM
Constitution which in fact do not even prescribe a... by William Whitten on Wednesday, Dec 31, 2008 at 7:37:07 PM
William,It is not clear to me from your reference ... by mike montagne on Thursday, Jan 1, 2009 at 3:34:49 PM
Jack, The reason a private bank (or set of private... by mike montagne on Wednesday, Jan 7, 2009 at 1:19:08 PM
"We are free from the constraints of Gold, we... by Peter Duveen on Monday, Dec 29, 2008 at 9:57:26 PM
The thing is, money is not a commodity, or it shou... by pft on Tuesday, Dec 30, 2008 at 5:47:19 PM
IT is indeed possible to create a currency by prin... by Peter Duveen on Saturday, Jan 3, 2009 at 7:58:12 AM
Peter,We must observe at the same time that "... by mike montagne on Saturday, Jan 3, 2009 at 1:39:30 PM
I have tried to look over a few of your other post... by Peter Duveen on Saturday, Jan 3, 2009 at 5:45:47 PM
Hi, Peter.I'll take each of your points or que... by mike montagne on Monday, Jan 5, 2009 at 2:25:14 PM
Another good article.  The Ponzi portion come... by August Adams on Monday, Dec 29, 2008 at 11:04:44 PM
Ellen, you ended the first section by stating that... by Jim Eldon on Tuesday, Dec 30, 2008 at 12:14:09 AM
You're right, it is interest that throws the s... by Ellen Brown on Tuesday, Dec 30, 2008 at 6:48:47 AM
It's not because the interest goes to private ... by Jim Eldon on Tuesday, Dec 30, 2008 at 11:33:20 AM
"that throws the system off"Where do you... by mike montagne on Tuesday, Dec 30, 2008 at 2:42:43 PM
We have a new word to play with! Ponzi!Now everybo... by Richard Hirschhorn on Tuesday, Dec 30, 2008 at 10:03:17 AM
The point was that everyone is shocked -- shocked!... by Ellen Brown on Tuesday, Dec 30, 2008 at 10:40:03 AM
You know, you're the only person I've even... by mike montagne on Tuesday, Dec 30, 2008 at 5:37:46 PM
You obviously don't watch CNBC.... by Ellen Brown on Tuesday, Dec 30, 2008 at 6:31:51 PM
I don't watch Captain Kangaroo or Mayor Art ei... by mike montagne on Tuesday, Dec 30, 2008 at 11:35:17 PM
Where do you get these terms, Ellen, "Ponzi S... by mike montagne on Tuesday, Dec 30, 2008 at 11:47:01 AM
I agree; the reason our current system is mathemat... by Ellen Brown on Tuesday, Dec 30, 2008 at 12:11:02 PM
This is monetized taxation and doesn't address... by Jim Eldon on Tuesday, Dec 30, 2008 at 1:02:02 PM
This answers the questions of my post? &q... by mike montagne on Tuesday, Dec 30, 2008 at 1:07:00 PM
The reason for interest has always been, not to co... by Ellen Brown on Tuesday, Dec 30, 2008 at 1:27:02 PM
"The reason for interest has always been, not... by mike montagne on Tuesday, Dec 30, 2008 at 2:32:05 PM
Amidst all that interest and debt, perhaps you can... by Jack Hughes on Tuesday, Dec 30, 2008 at 1:55:11 PM
Just because  you can cite a Ponzi scheme doe... by mike montagne on Tuesday, Dec 30, 2008 at 2:38:50 PM
Now let's address your assertion that the Penn... by mike montagne on Tuesday, Dec 30, 2008 at 1:21:49 PM
I don't understand your question.  See my... by Ellen Brown on Tuesday, Dec 30, 2008 at 1:29:38 PM
Then you don't have any business writing about... by mike montagne on Tuesday, Dec 30, 2008 at 1:33:50 PM
There are 3 questions. Let's see if we can wade th... by mike montagne on Tuesday, Dec 30, 2008 at 3:24:31 PM
Ellen,If you didn't answer this question in yo... by mike montagne on Wednesday, Dec 31, 2008 at 4:10:45 PM
Yes, it's all fraud, because the whole arrangement... by mike montagne on Tuesday, Dec 30, 2008 at 2:56:56 PM
Correct me if I'm wrong, but I believe I read ... by Ellen Brown on Tuesday, Dec 30, 2008 at 3:18:54 PM
Mike,Honestly, a little less abrasive tone in your... by William Whitten on Tuesday, Dec 30, 2008 at 6:27:39 PM
 "Mike,Honestly, a little less abrasive ... by mike montagne on Wednesday, Dec 31, 2008 at 12:35:36 AM
I get it Mike...I wrote a longer responce to this ... by William Whitten on Wednesday, Dec 31, 2008 at 9:39:38 PM
You're very welcome, William! Thank you for yo... by mike montagne on Thursday, Jan 1, 2009 at 1:31:36 PM
I will actually need to take my time and carefully... by Abe_Lincoln_in2012 on Tuesday, Dec 30, 2008 at 4:15:21 PM
Thanks Abe, I'd love to have some help here!&n... by Ellen Brown on Tuesday, Dec 30, 2008 at 5:03:20 PM
When a person advocates a monetary solution, the v... by mike montagne on Tuesday, Dec 30, 2008 at 5:22:40 PM
I do apologize to others for my tone, but let me g... by mike montagne on Tuesday, Dec 30, 2008 at 5:07:22 PM
You are incorrect enough that you should be correc... by mike montagne on Tuesday, Dec 30, 2008 at 4:46:59 PM
Let me just ask -- are you proposing to do away wi... by Ellen Brown on Tuesday, Dec 30, 2008 at 6:45:40 PM
"Let me just ask -- are you proposing to do a... by mike montagne on Wednesday, Dec 31, 2008 at 2:16:14 AM
Mike,I got ya! I have made my own paltry attempts ... by William Whitten on Tuesday, Dec 30, 2008 at 9:10:47 PM
William,Here's a paper I did on that issue, wh... by mike montagne on Wednesday, Dec 31, 2008 at 12:41:44 AM
The route of the courts is a good one...but the co... by William Whitten on Wednesday, Dec 31, 2008 at 9:20:42 PM
William,Alright... we don't want to fight anot... by mike montagne on Thursday, Jan 1, 2009 at 3:45:50 PM
If I understand you clearly, you speak of the type... by William Whitten on Thursday, Jan 1, 2009 at 7:35:43 PM
You're absolutely right about that danger -- o... by mike montagne on Saturday, Jan 3, 2009 at 12:48:13 PM
I've actually made many of those arguments in ... by Ellen Brown on Tuesday, Dec 30, 2008 at 10:35:18 PM
"I've actually made many of those argumen... by mike montagne on Wednesday, Dec 31, 2008 at 1:36:33 PM
The point of this of course is that the "many... by mike montagne on Tuesday, Jan 6, 2009 at 11:11:14 AM
I agree, interest serves a purpose, if not excessi... by pft on Tuesday, Dec 30, 2008 at 6:13:40 PM
There is no such thing as "fair" interes... by mike montagne on Thursday, Jan 1, 2009 at 4:04:35 PM
As I wrote to Mike privately awhile ago, the essen... by Jim Eldon on Tuesday, Dec 30, 2008 at 8:06:23 PM
To whom would they be issuing this promise to pay,... by Ellen Brown on Tuesday, Dec 30, 2008 at 9:32:56 PM
"To whom would they be issuing this promise t... by Jim Eldon on Tuesday, Dec 30, 2008 at 10:00:55 PM
Jim is a recent visitor to our pages (I think), at... by mike montagne on Wednesday, Dec 31, 2008 at 1:53:16 PM
That's beautifully, and perfectly said.I have ... by mike montagne on Wednesday, Dec 31, 2008 at 2:02:25 PM
I found this bit of history (if it is to be believ... by Tom Chechatka on Tuesday, Dec 30, 2008 at 8:27:43 PM
Tom,If you haven't, you should read a book on ... by William Whitten on Tuesday, Dec 30, 2008 at 9:18:18 PM
William,A problem with G. Edward Griffin. The Crea... by mike montagne on Wednesday, Dec 31, 2008 at 2:24:13 AM
Look Mike,I know that the model you want to see de... by William Whitten on Wednesday, Dec 31, 2008 at 1:35:22 PM
You're absolutely right, William.But why then ... by mike montagne on Wednesday, Dec 31, 2008 at 2:23:16 PM
Dear Ellen,    Bravo! (again) ... by James Hayhurst on Wednesday, Dec 31, 2008 at 10:45:38 AM
So can you tell us James, why and how the banking ... by mike montagne on Wednesday, Dec 31, 2008 at 2:26:05 PM
My background is NOT in economics or banking but i... by truthseeker7 on Wednesday, Dec 31, 2008 at 11:58:10 AM
Well... on the humorous side, we differ in describ... by mike montagne on Wednesday, Dec 31, 2008 at 3:59:03 PM
HAPPY NEW YEAR!... by mike montagne on Wednesday, Dec 31, 2008 at 4:06:24 PM
To all. In my final analysis, I am in agreement wi... by William Whitten on Wednesday, Dec 31, 2008 at 9:46:42 PM
The issue isn't so much who owns it, as the fa... by mike montagne on Thursday, Jan 1, 2009 at 1:40:05 AM
Mike, your page on McFadden is one one the most br... by William Whitten on Thursday, Jan 1, 2009 at 4:45:19 AM
In a different post, Ellen wondered why we need cr... by John Bessa on Thursday, Jan 1, 2009 at 2:18:55 PM
Real, natural "growth" or retirement of ... by mike montagne on Thursday, Jan 1, 2009 at 4:26:21 PM
William,I want to point out for others how importa... by mike montagne on Thursday, Jan 1, 2009 at 2:54:51 PM
Mike writes: Furthermore, unless we are completely... by John Bessa on Thursday, Jan 1, 2009 at 7:15:06 PM
John,Your questions revolve primarily around the a... by William Whitten on Thursday, Jan 1, 2009 at 7:57:16 PM
"Is that linked to usury in some way, or is i... by William Whitten on Thursday, Jan 1, 2009 at 8:31:19 PM
  The ancient Sun Tzu is more relevant today;... by William Whitten on Thursday, Jan 1, 2009 at 8:24:39 PM
 I am taking a psycho- and sociological appro... by John Bessa on Friday, Jan 2, 2009 at 5:58:24 PM
"Beyond this I would like to present the idea... by William Whitten on Saturday, Jan 3, 2009 at 11:37:24 PM
"Why can't we pay for a house with a hous... by Felix Billington on Friday, Jan 2, 2009 at 10:40:47 AM
Felix,You need to learn some history--try that bef... by William Whitten on Friday, Jan 2, 2009 at 10:06:36 PM
You wouldn't like us when we're angry. I&... by Felix Billington on Saturday, Jan 3, 2009 at 11:53:16 PM
"You wouldn't like us when we're angr... by mike montagne on Tuesday, Jan 6, 2009 at 12:35:35 PM
Dorothy,You start out ignoring everything in your ... by mike montagne on Tuesday, Jan 6, 2009 at 1:09:29 PM
Dear Mike,You are right. I stand corrected. After ... by James Hayhurst on Friday, Jan 2, 2009 at 1:42:49 PM
Jim,I appreciate your remarks, and yet in response... by mike montagne on Saturday, Jan 3, 2009 at 3:44:34 PM
For the many non-Christians (and Christians) who d... by James Hayhurst on Friday, Jan 2, 2009 at 2:11:18 PM
Sorry, try this: http://www.youtube.com/watch?v=TM... by James Hayhurst on Friday, Jan 2, 2009 at 2:17:47 PM
I guess this discussion is finally doneSo I will j... by John Bessa on Saturday, Jan 3, 2009 at 9:48:22 AM
John,There is no such thing as a "free market... by mike montagne on Saturday, Jan 3, 2009 at 3:55:12 PM
I have to go w/ science and Einstein again: In Sci... by John Bessa on Sunday, Jan 4, 2009 at 10:49:03 AM
John,You pretend after all this, to simply disprov... by mike montagne on Monday, Jan 5, 2009 at 12:45:52 PM
John,Your argument that science must be tailored t... by mike montagne on Monday, Jan 5, 2009 at 12:59:22 PM
John,Nothing then better proves the transgression ... by mike montagne on Tuesday, Jan 6, 2009 at 12:45:50 PM

 

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