The Wall Street Ponzi Scheme called
"Fractional Reserve" Banking
by Ellen Brown
December 29, 2008
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
"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."
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
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
"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
"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.
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
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
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.'"
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. 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
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.