EWI's Message Board is a happening place -- not a day goes by without readers asking thought-provoking questions. Here's one that just came in:
6/29/2009 11:34:27 AM -- Dear EWI, as the Madoff hoopla is going full blast today on TV, I would be interested to hear your thoughts on this question: Are today's banks in their vast majority also massive Ponzi schemes?
Answering a question like that can be a simple matter of definitions. Getting definition for Ponzi schemes is easy; here's Wikipedia's.
A Ponzi scheme is a fraudulent investment operation that pays returns ... from ... money paid by subsequent investors rather than from any actual profit earned.
But to define the U.S. banking system is not as easy. For that, I've had to turn to a real expert: Robert Prechter, EWI's founder and president. Here's what Bob writes in Chapter 10 of his Conquer the Crash*, "Money, Credit and the Federal Reserve Banking System" (excerpt; italics added):
Under the structure of our “fractional reserve” system, banks ... were allowed by regulation to lend out 90 percent of their deposits, which meant that banks had to keep 10 percent of deposits on hand (“in reserve”) to cover withdrawals. Because of competition from money market funds, banks began using fancy financial manipulation to get around reserve requirements. In the early 1990s, the Federal Reserve Board under Chairman Alan Greenspan took a controversial step and removed banks’ reserve requirements almost entirely.
To do so, it first lowered to zero the reserve requirement on all accounts other than checking accounts. Then it let banks pretend that they have almost no checking account balances by allowing them to “sweep” those deposits into various savings accounts and money market funds at the end of each business day. Magically, when monitors check the banks’ balances at night, they find the value of checking accounts artificially understated by hundreds of billions of dollars. The net result is that banks today conveniently meet their nominally required reserves (currently about $45b.) with the cash in their vaults that they need to hold for everyday transactions anyway.
By this change in regulation, the Fed essentially removed itself from the businesses of requiring banks to hold reserves and of manipulating the level of those reserves. This move took place during a recession and while S&P earnings per share were undergoing their biggest drop since the 1940s. The temporary cure for that economic contraction was the ultimate in “easy money.”
We still have a fractional reserve system on the books, but we do not have one in actuality. Now banks can lend out virtually all of their deposits. In fact, they can lend out more than all of their deposits, because banks’ parent companies can issue stock, bonds, commercial paper or any financial instrument and lend the proceeds to their subsidiary banks, upon which assets the banks can make new loans. In other words, to a limited degree, banks can arrange to create their own new money for lending purposes. Today, U.S. banks have extended 25 percent more total credit than they have in total deposits ($5.4 trillion vs. $4.3 trillion). Since all banks do not engage in this practice, others must be quite aggressive at it. For more on this theme, see Chapter 19.
Recall that when banks lend money, it gets deposited in other banks, which can lend it out again. Without a reserve requirement, the multiplier effect is no longer restricted to ten times deposits; it is virtually unlimited. Every new dollar deposited can be lent over and over throughout the system: A deposit becomes a loan becomes a deposit becomes a loan, and so on. As you can see, the fiat money system has encouraged inflation via both money creation and the expansion of credit. The effective elimination of reserve requirements a decade ago extended that trend to one of historic proportion.
So, are today's banks "massive Ponzi schemes"? No, I wouldn't go that far. But you have to agree that there are some parallels. A Ponzi scheme can only pay out as long as there are new deposits. If a bank lends out all of its deposits -- or even 25% over that amount -- what happens if a lot of customers want to make withdrawals at once? Oh, right -- there is the safety net of the Federal Reserve Bank...
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*You get a free copy of Robert Prechter's Conquer the Crash with an instant, risk-free subscription to EWI's latest intermediate-term forecasts in these July publications: