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scheme has reached its mathematical limits and needs to be superseded by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
“4. There are usually enough cash reserves in the bank to handle net
“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.
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