CREDIT in the US banking system has dried up and many banks cannot meet the eight per cent capital requirement that limits their ability to lend.

A bank’s capital — the money it gets from the sale of stock or from profits — can be fanned into more than 10 times its value in loans; but this leverage also works the other way. While $80 in capital can produce $1,000 in loans, an $80 loss from default wipes out $80 in capital, reducing the sum that can be lent by $1,000. Since the banks have been experiencing widespread loan defaults, their capital base has shrunk proportionately.

The bank bailout plan announced on October 3 involved using taxpayer money to buy up mortgage-related securities from troubled banks. This was supposed to reduce the need for new capital by reducing the amount of risky assets on the banks’ books. But the banks’ risky assets include derivatives — speculative bets on market changes — and derivative exposure for US banks is now estimated at a breathtaking $180 trillion.

The sum represents an impossible-to-fill black hole that is three times the gross domestic product of all the countries in the world combined. Even if $700 billion of taxpayer money were fanned into $7 trillion, the sum would not come close to removing the $180 trillion in derivative liabilities from the banks’ books.

A significant move made by the Fed last week is its new “Commercial Paper Funding Facility,” which is slated to be operational on October 27, 2008. The facility would open the Fed’s lending window for short-term commercial paper, the money corporations need to fund their day-to-day business operations. On October 14, the Federal Reserve Bank of New York justified this extraordinary expansion of its lending powers by stating: “The US Treasury believes this facility is necessary to prevent substantial disruptions to the financial markets and the economy and will make a special deposit at the New York Fed in support of this facility.”

That means the government and the Fed are now committing even more public money and taking on even more public risk. The taxpayers are already tapped out, so the Treasury’s “special deposit” will no doubt come from US bonds, meaning more debt on which the taxpayers have to pay interest.

The federal debt could wind up running so high that the government loses its own triple-A rating. Rather than solving the problem, these “rescue” plans seem destined to make it worse.

Ponzi Scheme: All the king’s men cannot put the private banking system together again, for the simple reason that it is a Ponzi scheme that has reached its mathematical limits. A Ponzi scheme is a form of pyramid scheme in which new investors must continually be sucked in at the bottom to support the investors at the top. In this case, new borrowers must continually be sucked in to support the creditors at the top. The Wall Street Ponzi scheme is built on “fractional reserve” lending, which allows banks to create “credit” (or “debt”) with accounting entries. Banks are now allowed to lend from 10 to 30 times their “reserves,” essentially counterfeiting the money they lend.

Over 97 percent of the US money supply has been created by banks in this way. The problem is that banks create only the principal and not the interest necessary to pay back their loans. Since bank lending is essentially the only source of new money in the system, someone somewhere must continually be taking out new loans just to create enough “money” (or “credit”) to service the old loans composing the money supply.

This spiraling interest problem and the need to find new debtors has gone on for over 300 years -- ever since the founding of the Bank of England in 1694 — until the whole world has now become mired in debt to the bankers’ private money monopoly.

The parasite has finally run out of its food source. But the crisis is not in the economy itself, which is fundamentally sound — or would be with a proper credit system to oil the wheels of production. The crisis is in the banking system, which can no longer cover up the shell game it has played for three centuries with other people’s money. Fortunately, we don’t need the credit of private banks. A sovereign government can create its own.

A system of public banks might be set up that had the power to create credit themselves, just as private banks do now. A public bank operating on the private bank model could fan $700 billion in capital reserves into $7 trillion in public credit that was derivative-free, liability-free, and readily available to fund all those things we think we don’t have the money for now, including the loans necessary to meet payrolls, fund mortgages, and underwrite public infrastructure.

Credit as a public utility: “Credit” can and should be a national utility, a public service provided by the government to the people it serves. Many people are opposed to getting the government involved in the banking system, but the fact is that the government is already involved. A modern-day Reconstruction Finance Corporation (RFC)-a federally-owned bank set up by President Hoover in 1932- would actually mean less government involvement and a more efficient use of the already-earmarked $700 billion than policymakers are talking about now.

The government would not need to interfere with the private banking system, which could carry on as before. The Treasury would not need to bailout the banks, which could be left to those same free market forces that have served them so well up to now. If banks went bankrupt, they could be put into FDIC receivership and nationalised.

The government would then own a string of banks, which could be used to service the depository and credit needs of the community. There would be no need to change the personnel or procedures of these newly-nationalised banks. They could engage in “fractional reserve” lending just as they do now. The only difference would be that the interest on loans would return to the government, helping to defray the tax burden on the populace; and the banks would start out with a clean set of books, so their $700 billion in startup capital could be fanned into $7 trillion in new loans. This was the sort of banking scheme used in Benjamin Franklin’s colony of Pennsylvania, where it worked brilliantly well. The spiraling-interest problem was avoided by printing some extra money and spending it into the economy for public purposes. During the decades the provincial bank operated, the Pennsylvania colonists paid no taxes, there was no government debt, and inflation did not result.

Like the Pennsylvania bank, a modern-day federal banking system would not actually need “reserves” at all. It is the sovereign right of a government to issue the currency of the realm. What backs the dollar today is simply “the full faith and credit of the United States,” something the United States should be able to issue directly without having to draw on “reserves” of its own credit. But if Congress is not prepared to go that far, a more efficient use of the earmarked $700 billion than bailing out failing banks would be to designate the funds as the “reserves” for a newly-reconstituted RFC.

As the US private banking system self-destructs, it needs to ensure that a public credit system is in place and ready to serve the people’s needs in its stead.