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     Jun 7, 2011

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This crisis has an exit
By Ellen Brown

Countries everywhere are facing debt crises today, precipitated by the credit collapse of 2008. Public services are being slashed and public assets are being sold off, in a futile attempt to balance budgets that can't be balanced because the money supply itself has shrunk. Governments usually get the blame for excessive spending, but governments did not initiate the crisis. The collapse was in the banking system, and in the credit that it is responsible for creating and sustaining.

Contrary to popular belief, most of our money today is not created by governments. It is created by private banks as loans. The private system of money creation has grown so powerful over the centuries that it has come to dominate governments globally. The system, however, contains the seeds of its own destruction. The

source of its power is also a fatal design flaw.

The flaw is that banks advance "bank credit" that must be paid back with interest, continually requiring more money to be repaid than was created as loans; the only way to get additional money from the private banking system is to take out yet more loans, at interest. The system is, in effect, a pyramid scheme. When the banks run out of borrowers to support the pyramid, it must collapse; and we are nearing that point today.

There are more sustainable ways to run a banking and credit system, as will be shown.

How banks create money
The process by which banks create money was explained by the Chicago Federal Reserve in a booklet called Modern Money Mechanics. It states:
  • "The actual process of money creation takes place primarily in banks." [p3]
  • "[Banks] do not really pay out loans from the money they receive as deposits. If they did this, no additional money would be created. What they do when they make loans is to accept promissory notes in exchange for credits to the borrowers' transaction accounts. Loans (assets) and deposits (liabilities) both rise [by the same amount]." [p6]
  • "With a uniform 10 percent reserve requirement, a $1 increase in reserves would support $10 of additional transaction accounts." [p49]
  • A $100 deposit supports a $90 loan, which becomes a $90 deposit in another bank, which supports an $81 loan, etc.

    That's the conventional model, but banks actually create the loans first. They find the deposits to meet the reserve requirement later. Banks create money as loans, which become checks, which go into other banks. Then, if needed to clear the checks, they borrow the money back from the other banks. In effect, they borrow back the money they just created, pocketing the spread between the interest rates as their profit. The rate at which banks can borrow from each other in the United States today - the Fed funds rate - is an extremely low 0.2%.

    How the system evolved
    The current system of privately issued money is traced in Modern Money Mechanics to the 17th century goldsmiths. People who left gold with the goldsmiths for safekeeping would be issued paper receipts for it called "banknotes". Other people who wanted to borrow money were also happy to accept paper banknotes in place of gold, since the notes were safer and more convenient to carry around.

    The sleight of hand came in when the goldsmiths discovered that people would come for their gold only about 10% of the time. That meant that up to 10 times as many notes could be printed and lent as the goldsmiths had gold. Ninety percent of the notes were basically counterfeited.

    This system is called "fractional reserve" banking and was institutionalized when the Bank of England was founded in 1694. The bank was allowed to lend its own banknotes to the government, forming the national money supply. Only the interest on the loans had to be paid. The debt was rolled over indefinitely.

    That is still true today. The US federal debt is never paid off but just continues to grow, forming the basis of the US money supply.
    The public banking alternative
    There are other ways to create a banking system, ways that would eliminate its Ponzi-scheme elements and make the system sustainable. One solution is to make the loans interest-free; but for Western economies today, that transition could be difficult.

    Another alternative is for banks to be publicly owned. If the people collectively own the bank, the interest and profits go back to the government and the people, who benefit from decreased taxes, increased public services, and cheaper public infrastructure. Cutting out interest has been shown to reduce the cost of public projects by 30-50%.

    In the United States, this system of publicly owned banks goes back to the American colonists. The best of the colonial models was in Benjamin Franklin's colony of Pennsylvania, where the government operated a "land bank". Money was printed and lent into the community. It recycled back to the government and could be lent and relent.

    The system was mathematically sound because the interest and profits returned to the government, which then spent the money back into the economy in place of taxes. Private banks, by contrast, generally lend their profits back into the economy, or invest in private money-making ventures in which more is always expected back than was originally invested.

    During the period that the Pennsylvania system was in place, the colonists paid no taxes except excise taxes, prices did not inflate, and there was no government debt.

    How private banknotes became the national US currency
    The Pennsylvania credit system was sustainable, but some early American colonial governments just printed and spent, inflating the money supply and devaluing the currency. The British merchants complained, prompting King George II to forbid the colonists to issue their own money.

    Taxes had to be paid to England in gold. That meant going into debt to the English bankers. The result was a massive depression. The colonists finally rebelled and went back to issuing their own money, precipitating the American Revolution.

    In an international first, the colonists funded a war against a major power with mere paper receipts, and won. But the British counterattacked by waging a currency war. They massively counterfeited the colonists' paper money at a time when this was easy to do. By the end of the war, the paper scrip was virtually worthless. After it lost its value, the colonists were so disillusioned with paper money that they left the power to issue it out of the US constitution.

    Meanwhile, Alexander Hamilton, the first US Treasury Secretary, was faced with huge war debts, and he had no money to pay them. He therefore resorted to the ruse used in England known as fractional reserve banking. In 1791, Hamilton set up the First US Bank, a largely private bank that would print banknotes "backed" by gold and lend them to the government.

    The ruse worked: the paper banknotes expanded the money supply, the debts were paid, and the economy thrived. But it was the beginning of a system of government funded by debt to private bankers, who lent banknotes only nominally backed by gold.

    During the American Civil War (1861–1865), president Abraham Lincoln avoided a crippling war debt by returning to the system of government-issued money of the American colonists. He issued US Notes from the Treasury called "Greenbacks" rather than borrowing at usurious interest rates. But Lincoln was assassinated, and Greenback issuance was halted.

    In 1913, the privately owned Federal Reserve was authorized to issue its own Federal Reserve Notes as the national currency. These notes were then lent to the government, eliminating the government's own power to issue money (except for coins). The Federal Reserve was set up to prevent bank runs, but 20 years later we had the Great Depression, the greatest bank run in history. Robert H Hemphill, credit manager of the Federal Reserve Bank of Atlanta, wrote in 1934:
    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.

    Continued 1 2  

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