Panic struck on Wall Street, as the Dow Jones Industrial Average plunged a thousand points between July and August, and commentators warned of a 1929-style crash. To prevent that dire result, the U.S. Federal Reserve, along with the central banks of Europe, Canada, Australia and Japan, stepped up to the plate and extended a 315 billion dollar lifeline to troubled banks and investment firms. The hemorrhage stopped, the markets turned around, and investors breathed a sigh of relief. All was well again in Stepfordville. Or was it? And if it was, at what cost? Three hundred billion dollars is about a third of the total paid by U.S. taxpayers in personal income taxes annually. A mere $188 billion would have been enough to repair all of the 74,000 U.S. bridges known to be defective, preventing another disaster like that seen in Minneapolis in July. But the central banks' $300 billion did not go for anything so socially useful as rebuilding infrastructure. Rather, it was poured into the black hole of rescuing the very banks and hedge funds that were blamed for precipitating the crisis, encouraging them to continue in their profligate ways.

Where did the central banks find this $300 billion? Central banks are "lenders of last resort." According to an article in the Federal Reserve Bank of Atlanta's Economic Review, "to function as a lender of last resort [a central bank] must have authority to create money, i.e., provide unlimited liquidity on demand."1 In other words, central banks are authorized to create money out of thin air. Increasing the money supply ("demand") without increasing goods and services ("supply") is highly inflationary. However, the authority is said to be necessary because the banking system is inherently prone to crises and market failures, and a lender of last resort with the ability to bail out the banks in a crisis is essential to maintaining a smoothly running economy.2 Periodic "busts" have followed "booms" so regularly and predictably in the last 300 years that the phenomenon has been dubbed the "business cycle," as if it were an immutable trait of free markets like the weather. In fact, however, this cycle is an immutable trait only of a banking system based on the sleight of hand known as "fractional-reserve" lending. The banks themselves routinely create money out of thin air, and they need a lender of last resort to back them up whenever they get caught short in this sleight of hand.

Running through this whole drama is a larger theme, one that nobody is talking about and that can't be cured by fiddling with interest rates or throwing liquidity at banks making too-risky loans. The reason the modern central banking system is prone to periodic crises and market failures is that it is a Ponzi scheme, one that is basically a fraud on the people. Like all Ponzi schemes, it can go on only so long before it reaches its mathematical limits; and there is good evidence that we are there now. If we are to avoid the greatest market crash in history, we will need to eliminate the underlying fraud; and the first step in that process is to understand what is really going on.

The 300 Year Ponzi Scheme Known as "Fractional-Reserve" Lending

A Ponzi scheme is a form of pyramid scheme in which earlier players are paid with the money of later players, until no more unwary investors are available to be sucked in at the bottom and the pyramid collapses, leaving the last investors in holding the bag. Our economic Ponzi scheme dates back to Oliver Cromwell's "Glorious Revolution" in seventeenth century England. Before that, the power to issue money was the sovereign right of the King, and for anyone else to do it was considered treason. But Cromwell did not have access to the Sovereign's money-creating power, so he had to borrow from foreign moneylenders to fund his revolt; and they agreed to lend only on condition that they be allowed back into England, from which they had been banned centuries earlier. In 1694, the Bank of England was chartered to a group of private moneylenders, who were allowed to print paper banknotes and lend them to the government at interest; and these private banknotes became the national money supply. They were ostensibly backed by gold; but under the fractional-reserve lending scheme, the amount of gold the lenders held in "reserve" was only a fraction of the value of the notes they actually printed and lent. This practice grew out of the discovery of the earlier goldsmiths, that customers who left their gold for safekeeping would come for it only about 10 percent of the time. Ten paper banknotes "backed" by a pound of gold could therefore safely be printed and lent for every pound of gold the goldsmiths actually held in reserve.

The Bank of England became the pattern for the system known today as "central banking." A single bank, usually privately owned, is given a monopoly over the issue of the nation's currency, which is then lent to the government, usurping the government's sovereign power to create money itself. In the United States, formal adoption of this system dates to the Federal Reserve Act of 1913; but private banks have created the national money supply ever since the country was founded. Before 1913, multiple private banks issued their own banknotes with their own names on them. Like the Bank of England's notes, these notes were ostensibly backed by gold; but the banks issued notes valued at many times the gold they actually had in their vaults. The scheme worked fairly well, until the customers periodically got suspicious and all demanded their gold at the same time, when there would be a "run" on the banks and they would have to close their doors. The Federal Reserve (or "Fed") was instituted to rescue the banks from this sort of crisis by acting as "lender of last resort," a bankers' bank able to create money out of nothing and lend it to the banks on demand. The banks themselves had already been creating money out of nothing for two centuries, but the Federal Reserve served as a backup source, generating the customer confidence necessary to carry on with the banks' fractional-reserve lending scheme.

Today, the only money issued by the U.S. government consists of coins, which compose only about one one-thousandth of the M3 money supply. (M3 was the broadest money supply measure reported by the Fed until 2006, when its reporting was mysteriously stopped, perhaps to avoid alarm at the true numbers.) Federal Reserve Notes (dollar bills) are issued by the Federal Reserve, a private banking corporation, and lent to the government and to commercial banks. Coins and Federal Reserve Notes together, however, compose less than 3 percent of the M3 money supply. The other 97 percent is created by commercial banks when they make loans.3

The notion that virtually all of our money has been created by private banking institutions is so foreign to what we have been taught that it can be difficult to grasp, but many reputable authorities have attested to it. Robert H. Hemphill, Credit Manager for the Federal Reserve Bank of Atlanta in the 1930s, summed up the situation like this:
We are completely dependent on the commercial Banks. Someone has to borrow every dollar we have in circulation, cash or credit. If the Banks create ample synthetic money we are prosperous; if not, we starve. We are absolutely without a permanent money system. When one gets a complete grasp of the picture, the tragic absurdity of our hopeless position is almost incredible, but there it is.4
Robert B. Anderson, Secretary of the Treasury under Eisenhower, said in a 1959 interview:
[W]hen a bank makes a loan, it simply adds to the borrower's deposit account in the bank by the amount of the loan. The money is not taken from anyone else's deposit; it was not previously paid in to the bank by anyone. It's new money, created by the bank for the use of the borrower.5
Among other problems with this private system of money creation is that banks create the principal but not the interest necessary to pay back their loans; and that is where the Ponzi scheme comes in. Since loans, either from the Federal Reserve or from commercial banks, are the only source of new money in the economy, additional borrowers must continually be found to take out new loans to expand the money supply, in order to pay the interest creamed off the top by the bankers. New sources of debt are fanned into "bubbles" (rapidly rising asset prices), which expand until they "pop," with new bubbles replacing old ones when they burst, until finally no more new borrowers can be found and the pyramid collapses.

Before the dollar was taken off the gold standard in 1933, the tether of gold served to limit the amount by which debt bubbles could expand. Cycles of booms or inflations were followed by busts or depressions, when the bankers called in their loans, homes went into foreclosure, the money supply shrank, and the cycle would begin all over again. But after 1933, the Federal Reserve, which was blamed for inducing the Great Depression, took it upon itself to prevent any more such national disasters. Whenever the economy slipped into its "bust" cycle, the Fed would pump up the shrinking money supply by injecting more liquidity into the system, usually by lowering interest rates. This would increase the debt-money in the system by encouraging further borrowing. When collapse of the savings and loan associations in the 1980s precipitated a recession, the Fed lowered interest rates and fanned the stock market bubble of the 1990s. When that bubble burst in 2000, the Fed dropped interest rates even more, creating the housing bubble of the current decade. When lenders ran out of "prime" borrowers, they turned to "subprime" borrowers - those who would not have qualified under the older, tougher standards. It was all part of the structural imperative inherent in all Ponzi schemes, that the inflow of cash must continually expand to pay the people at the top of the pyramid. As with all Ponzi schemes, however, this expansion has mathematical limits. The Fed kept interest rates as low as it could for as long as it could; but in 2004, it had to begin raising rates to tame inflation and to make government bonds more attractive to investors, in order to support the burgeoning federal debt. The housing bubble was then punctured, and many subprime borrowers were thrown into default.

The Subprime Mess and the Derivatives Scam

At one time, borrowers had to come up with 20 percent down payments and prove they could meet monthly mortgage payments before they could get home mortgage loans. But in the ever-growing need to find new borrowers, lending standards were relaxed. Adjustable rate mortgages, interest-only loans, no- or low-down-payment loans, and no-documentation loans made "home ownership" available to virtually anyone who was willing to take the bait. The risks of these loans were minimized by off-loading them onto unsuspecting investors, particularly foreign investors. The loans were sliced up, bundled together with mortgages that had a better chance of being paid off, and sold as mortgage-backed securities called "collateralized debt obligations" (CDOs). In order to induce rating agencies to give CDOs triple-A ratings, "derivatives" were thrown into the mix, ostensibly protecting the investors from loss.

Derivatives are basically side bets that some underlying investment (a stock, commodity, market, etc.) will go up or down. They don't involve the purchase of an asset but are outside bets in the "futures" market - bets on what the asset will do in the future. Derivatives are sold by a small group of very big banks as "insurance" against the occurrence of some specific event. The most familiar types are "puts" (bets that an asset will go down) and "calls" (bets that the asset will go up). An investor can insure against the risk of an asset losing value by buying a put that will pay him if it does, neutralizing the risk. Over 90 percent of the derivatives held by banks today, however, are "over-the-counter" derivatives - investment devices specially tailored to financial institutions, often having exotic and complex features, not traded on standard exchanges. They are not regulated, are hard to trace, and are very hard to understand and to value.6 Some critics say that derivatives have been intentionally made impossible to understand, because they were designed to be so complex and obscure as to mislead investors.7

By the end of 2006, according to the Bank for International Settlements, the derivatives trade had grown to $415 trillion. This is a Ponzi scheme on its face, since the sum is nearly nine times the size of the entire world economy. A thing is worth only what it will fetch in the market, and there is no market anywhere on the planet that can afford to pay up on these speculative bets. The Ponzi-scheme nature of the derivatives phenomenon was illustrated by banking columnist John Hoefle using a colorful analogy:
During the 1980s, you had the creation of a huge financial bubble. . . . [Y]ou could look at that as fleas who set up a trading empire on a dog. . . . They start pumping more and more blood out of the dog to support their trading, and then at a certain point, the amount of blood that they're trading exceeds what they can pump from the dog, without killing the dog. The dog begins to get very sick. So being clever little critters, what they do, is they switch to trading in blood futures. And since there's no connection - they break the connection between the blood available and the amount you can trade, then you can have a real explosion of trading, and that's what the derivatives market represents. And so now you've had this explosion of trading in blood futures which is going right up to the point that now the dog is on the verge of dying. And that's essentially what the derivatives market is. It's the last gasp of a financial bubble.8
The current market implosion began when Bear Stearns, a large investment bank that had been buying CDOs through its hedge funds, closed two of its funds in June 2007. Hedge funds are investment companies employing high-risk techniques, including speculation in derivatives, in order to make extraordinary profits for their investors. Bear Stearns' two funds had to be closed due to doubts about the valuation of their CDOs. When the creditors tried to get their money back, the CDOs were put up for sale; and there were no takers at anywhere near the CDOs' stated valuations. Mark Gilbert, writing on Bloomberg.com, observed:
The efforts by Bear Stearns's creditors to extricate themselves from their investments have laid bare one of the derivatives market's dirty little secrets - prices are mostly generated by a confidence trick. As long as all of the participants keep a straight face when agreeing on a particular value for a security, that's the price. As soon as someone starts giggling, however, the jig is up, and the bookkeepers might have to confess to a new, lower price.9
The jig is up particularly for collateralized debt obligations (CDOs), and that puts the rest of the derivatives market in doubt. Closure of the Bear Stearns hedge funds set off alarm bells, spreading panic around the world as increasing numbers of investment banks had to prevent "runs" on their hedge funds by refusing withdrawals. When the problem became too big for the investment banks to handle, the central banks stepped in, something they consider it their job to do whenever there is a liquidity crisis. But in this case the crisis wasn't actually the result of a lack of money in the system. The bank-created money lent to subprime borrowers was still circulating in the economy; the borrowers just weren't paying it back to the banks. And investors still had money to invest; they just weren't willing to use it to buy "triple-A" mortgage-backed securities that had toxic subprime mortgages embedded in them. The "faith-based" money system devised by the bankers had been frozen into illiquidity because no one was "buying it" anymore.

That was when the central bankers extended their $300 billion lifeline. Among those financial institutions rescued was Countrywide Financial, the largest U.S. mortgage lender. Countrywide had been branded the next Enron, not only because it was facing bankruptcy but because it was guilty of some quite shady practices. It underwrote and sold hundreds of thousands of mortgages containing false and misleading information, which were then sold to the international banking and investment markets as "securities." The lack of "liquidity" in the markets was blamed directly on the corrupt practices at Countrywide and other lenders of its ilk. According to one analyst, "Entire nations are now at risk of their economies collapsing because of this fraud."10 But that did not deter the Fed from sending in a lifeboat. Countrywide was saved from insolvency when Bank of America bought $2 billion of its stock with a loan made available by the Fed at newly-reduced interest rates. Bank of America also got a nice windfall out of the deal, since when investors learned that Countrywide was being rescued, the stock it had just purchased with money borrowed from the Fed shot up.

Where did the Fed itself get the money? Chris Powell of GATA (the Gold Anti-Trust Action Committee) commented, "[I]n central banking, if you need money for anything, you just sit down and type some up and click it over to someone who is ready to do as you ask with it." He added:
If it works for the Federal Reserve, Bank of America, and Countrywide, it can work for everyone else. For it is no more difficult for the Fed to conjure $2 billion for Bank of America and its friends to "invest" in Countrywide than it would be for the Fed to wire a few thousand dollars into your checking account, calling it, say, an advance on your next tax cut or a mortgage interest rebate awarded to you because some big, bad lender encouraged you to buy a McMansion with no money down in the expectation that you could flip it in a few months for enough profit to buy a regular house.11
Which brings us to the point here: if deflation needs to be reversed by typing up money on a computer screen, it should be done by Congress itself, the publicly accountable entity that alone is authorized to create money under the Constitution.

The Way Out

Economic collapse has been the predictable end of all Ponzi schemes ever since the notorious Mississippi bubble of the eighteenth century. The only way out of this fix is to reverse the sleight of hand that got us into it. If new money is going to be pumped into the economy, it should be done, not by private banks for private profit, but by the collective body of the people through their representative government; and the money should be spent, not on bailing out banks and hedge funds that have lost highly speculative market gambles, but on socially productive services such as rebuilding national infrastructure. When the "liquidity" crisis is tackled by lending bank-created money into the economy at interest, the result is a spiraling vortex of debt and inflation. A better solution is to put debt-free money into consumers' pockets in the form of wages earned. Skilled workers are increasingly losing their jobs to "outsourcing." A government exercising its sovereign right to issue money could pay these workers to build needed infrastructure, such as power plants using "clean" energy and modern high-speed trains. The government could then charge users a fee for these services, recycling the money from the government to the economy and back again, avoiding inflation. When new money is spent to create new goods and services, supply increases along with demand, and prices remain stable. In China, prices have remained low for thousands of years, although new money has continually flooded into the country to pay for its cheap products. The explanation for this "Chinese paradox" is that the new money is used to produce new goods and services, keeping supply in balance with demand.

Other considerations aside, we simply cannot afford the bank bailouts coming down the pike. If hundreds of billions of dollars are required to avert a market collapse precipitated by a few failing hedge funds, what will the price tag be when the $400-plus trillion derivatives bubble collapses? Rather than bailing out banks that have usurped our sovereign right to create money, we the people need to reclaim that right for ourselves. We can skip the middlemen and create our own money, debt- and interest-free. As William Jennings Bryan said in the historic speech that won him the Democratic nomination for President in 1896:
We say in our platform that we believe that the right to coin money and issue money is a function of government. . . . Those who are opposed to this proposition tell us that the issue of paper money is a function of the bank and that the government ought to go out of the banking business. I stand with Jefferson . . . and tell them, as he did, that the issue of money is a function of the government and that the banks should go out of the governing business. . . . [W]hen we have restored the money of the Constitution, all other necessary reforms will be possible, and . . . until that is done there is no reform that can be accomplished.
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1 James Barth, et al., "Financial Crises and the Role of the Lender of Last Resort," Federal Reserve of Atlanta Economic Review (January 1984), pages 58-67
2 George Selgin, "Legal Restrictions, Financial Weakening, and the Lender of Last Resort," Cato Journal, www.cato.org (1989).
3 See Ellen Brown, "Dollar Deception: How Banks Secretly Create Money," www.webofdebt.com (July 3, 2007).
4 In the Foreword to Irving Fisher, 100% Money (1935), reprinted by Pickering and Chatto Ltd. (1996).
5 U.S. News and World Report (August 31, 1959).
6 R. Colt Bagley III, "Update: Record Derivatives Growth Ups System Risk," http://www.moneyfiles.org/specialgata04.html (July 29,2004).
7 See Gary Novak, "Derivatives Creating Global Economic Collapse," http://nov55.com/economy.html (June 30, 2006).
8 Interview of John Hoefle, "Hedge Fund Rescue, and What to Do with the Blow Out of the Bubble?," EIR Talks (October 2, 1998).
9 Mark Gilbert, "Opaque Derivatives, Transparent Fed, 'Bubblenomics'," www.bloomberg.com (June 27, 2007).
10 Alex Gabor, "The Penny King Declares 'SEC Should Investigate Mr. Mozillo of Countrywide Financial," www.americanchronicle.com (August 22, 2007).
11 Chris Powell, "Central Banking Is Easy; The Challenge Is to Stay in Power," www.gata.com (August 23, 2007).

Ellen Brown, J.D., 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. Brown's eleven books include the bestselling Nature's Pharmacy, co-authored with Dr. Lynne Walker, which has sold 285,000 copies