Ponzi Scheme and Modern Banking

Ponzi scheme has been a popular term ever since the Madoff incident. Madoff cheated investors by telling them he is making a moderate return every year and repay earlier investors with the money invested by later investors. The fact that it takes so long before it was discovered is worth a review.

The basic principle of modern banking involve getting deposits from people and institutions and then keep just a fraction of that as reserve and lend out the rest. The is called "Fractional Reserve Banking", which is used by all the banks on earth today. This practice is surprisingly new, only started around 200 years ago in the bank of Amsterdam. Before then, banks are the "guardian of gold";they keep full reserve and charge a fee for safekeeping your wealth.

In its simplest form, fractional reserve banking is almost an embezzlement. This system rely on the the "faith" that depositors will not get back their money at the same time and future depositors will refill the bank's reserve. That is why we need a central bank in case there are "bank runs". Modern bank, like the Ponzi scheme, rely on the fact that the chance of mass withdrawal is extremely small.

When you think of it this way, you really should be worried about your deposits. It is a gigantic Ponzi scheme - like operation, where most of your money isn't even there when you need it.

This fractional reserve system has many implications, as it alters the price of money (interest rate), the relationship between borrower and lender and inevitably contribute to the up and downs of the economy. This kind of practice systematically leads to over investment in good times and rapid monetary contractions in bad times; as the interest rate is now lower than the "natural" rate in the full reserve system. You will definitely charge higher interest rate than now if you must lend to the borrowers directly.

This system is also one of the causes of inflation, as money can be "created" in a fractional reserve system and the total amount of money in the economy can go faster than the actual increase of productivity.

Like all other bubbles, this kind of system may burst one day. I say "may be" because a bubble may never burst when everyone believes in it. So, next time when you see some wise old man, saying "all bubbles must burst" after the fact, you can assure that is bullshit, as we have a monetary bubble for 200 years and it never burst. Our governments actually support it!

This may all sound boring and useless, but those who understand from the basic concepts are much more reliable than people who only touch the surface.