Why is the fractional-reserve banking not a Ponzi scheme?
Operating a Ponzi scheme is a crime which I suppose has some sort of definition in the penal code or criminal law. It is a fraudulent investment operation that pays returns to separate investors from their own money or money paid by subsequent investors, rather than from any actual profit earned.
To my understanding this perfectly matches how fractional-reserve banking (involving fiat money) works. Since debt and the interest on the debt can only be paid in the same form of money, the total debt (principal plus interest) can never be paid in a debt-based monetary system unless more money is created through the same process. For example: if 100 credits are created and loaned into the economy at 10% per year, at the end of the year 110 credits will be needed to pay the loan and extinguish the debt. However, since the additional 10 credits does not yet exist, it too must be borrowed. This implies that debt must grow exponentially in order for the monetary system to remain solvent.
However, exponential growth can only be maintained over a finite period of time. Just in case of Ponzi schemes, during this time the scam works and investors are paid in full to attract future investors. Everyone believes therefore that the scheme works. But when the exponential growth slows down, the pyramid collapses. Mostly this happens quite quickly because the initial interest was high. Bernard Madoff's Ponzi scheme has shown that choosing a lower interest rate prolongs the time the scam works. Banks indeed work with even lower interest rates. (There could possibly be an equation showing how long a Ponzi scheme can operate depending on the promised interest.)
I do have basic understanding of economics and I'm not a paranoid capitalism hater. I just do not understand why the fractional-reserve banking could be possibly maintained indefinitely. Then why is it allowed for financial institutions to operate in such manner?
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It is possible to pay down debt (including interest) without issuing new debt money to pay for it. I think this is the heart of your question.
Let me present a highly contrived example in which society has four people and one bank.
Deposits
Adam - 0
Loans
none
Here is a bank with 0 in initial deposits. Total money supply in this society is 0. (We assume there is no currency circulating, since you're interested in debt money.)
This bank lends out to Bob at 1 year maturity and 10% APR. Bob spends this with Charlie to buy raw materials. Charlie deposits in the bank.
Deposits
Adam - 0
Charlie -
Loans
Bob -
The money supply just grew from 0 to 0.
Bob does something with the raw materials and adds some kind of value, eventually selling the finished goods for 0. In our little silly economy, the only people who have money are Adam and Charlie, so we must assume that between the two of them they buy 0 worth of goods from Bob. Let's say Adam buys and Charlie buys -- the actual amounts don't matter. Bob deposits this money at the bank.
Deposits
Adam -
Bob - 0
Charlie -
Loans
Bob -
Still 0 of money supply.
At the end of 1 year, Bob instructs the bank to transfer payment from his deposit account to his loan account. The bank wipes clean his debt and the money remaining in Bob's account represents his return.
Deposits
Adam -
Bob -
Charlie -
David -
Loans
none
Who is this David guy? He's the owner of the bank. He grosses in interest from the loan to Bob, and he pays to Adam as interest on Adam's deposit. The remaining is the profit to the bank's owner.
Money supply decreased from 0 to 0 after Bob pays off his loan.
I realized after writing this, the one thing I left out is, "where does Adam get 0 to start with?" Presumably Adam starts off with some kind of currency, either fiat money or commodity money. (IOW, debt money can't be created out of nothing, it has to be expanded on top of some kind of currency.)
They're not at all the same.
A Ponzi scheme is a fraudulent investment method that pays off early investors with deposits from later ones.
Fractional reserve banking is the practice of keeping only a fraction of a bank's demand deposits on reserve, while lending out the rest. The reserve requirement is how central banks limit the amount of money that can float around in commercial banks.
In the latter case, there is no "later investor" somewhere down near the bottom of a money food chain. Every dollar, regardless of whether it was created fresh from one of the federal reserve banks or created via several chained loans, is worth the same. If the dollars depreciate for whatever reason, they do so for everyone.
Now, if you want a good example of a Ponzi scheme that is actually legal, look at Social Security.
Edit: A "debt-based society" is separate from fractional-reserve banking. If the Fed creates ,000,000, the total amount of money that can float around is still capped based on whatever the reserve requirement is. (For a 10% reserve requirement, it's something like ,000,000.) We have unsustainable debt increases because of lack of self-control on the part of our leaders. The fractional-reserve process helps it along, but it's not the culprit. It's an enabler.
The Ponzi/Madoff schemes were closed loops, so the only source of the so-called "interest" on the money was the contributions of future investors. The economy is more like a living thing, and the availability of capital allows people to develop new ways to do things in a more productive way. Agriculture is a great example -- for most of human history the overwhelming majority of human labor was dedicated to producing food. Now that proportion is dramatically smaller -- the descendants of farmers 100 years ago are doctors and computer programmers... professions that could not exist.
Fractional reserve banking makes the economy more efficient by putting capital that would otherwise be hoarded in circulation. Money is a medium of exchange, so the more it turns over, the better it is. Genoa and Britain pioneered this concept centuries ago, and were able to defeat larger rivals in large part because of the economic advantages that the practice brought to bear.
That's not to say that banking doesn't come with its warts as well. I'd suggest reading "A Free Nation Deep in Debt", which does a good job of explaining how we got to where we are today.
Your question contains two different concepts: fractional reserve banking and debt-based money. When thinking of these two things I think it is important to analyze these items separately before trying to understand how the whole system works.
Fractional Reserve Banking
As others have pointed out fractional reserve banking is not a ponzi scheme. It can be fraudulent, however. If a bank tells all its depositors that they can withdrawal their money at any time (i.e. on demand) and the bank then proceeds to loan out some portion of the depositors' money then the bank has committed fraud since there is no way they could honor the depositors' requests for their money if many of them came for their money at one time. This is true regardless of what type of money is deposited - dollars, gold, etc.. This is how most modern banks operate.
Debt-based money
Historically, the Fed would introduce new money by buying US Treasuries. This means Federal Reserve Notes (FRN) are backed by US Treasuries. I agree that this seems strange. Does this mean if I take my FRNs to the Fed I could redeem them for US Treasuries? But US Treasuries are promises to pay FRNs in the future. This makes my head hurt. Reminds me of the definition for recursion: see recursion.
Here is an experiment. What if we wanted to recreate FRNs today and none existed? The US government would offer a note to pay 100 FRNs in one year and pay 5% interest on the note. The Fed would print up its first 100 FRNs to buy the note from the US government. The US government would spend the FRNs. The first 100 FRNs have now entered into circulation. At the end of the note's term the Fed should have 105 FRNs since the government agreed to pay 5% interest on the note. But how is the US government going to pay the interest and principal on the note when only 100 FRNs exist? I think this is the central point to your question.
I can come up with only two answers:
1) the Fed must purchase some assets that are not debt based
2) the US government must continue to issue debt that is purchased by newly printed FRNs in order to pay back older debt and interest. This is a ponzi scheme.
The record debt levels seem to indicate the ponzi scheme option was chosen.
The fundamental underlying difference between a bank and a Ponzi scheme:
A bank takes depositors' money, and lends it out to people who will (theoretically) pay it all back, and collects interest. This is frequently sustainable.
A Ponzi scheme takes depositor's money and uses it to pay the depositor as "interest". Then, before they run out of the first depositor's money, they try to attract more money. Eventually they must run out of people to take money from. It is fundamentally unsustainable.
When a bank lends money and charges interest, people can do things with that borrowed money which are worth it. (Building factories, starting businesses, or just enjoying the comfort and warmth of a single-family home instead of paying rent). This is why fractional-reserve banking is able to work.
People may also do things which do not necessarily turn a financial profit (financing large purchases on a credit card) but are worth it in terms of an expenditure. They may also do stupid things (financing useless purchases on a credit card and wasting their money) or otherwise dispose of the money poorly (the new business fails, the home's value plummets, etc).
A Ponzi scheme never really bothered to do useful things with the money.
Social Security has been mentioned. Part of social security's setup involves the current population of workers paying the current population of retirees; their own retirements will have to be financed by the next generation. This design is not intrinsically a Ponzi scheme: both the population and the economy ought to remain growing for the intermediate future, so there will be at least as much money (and probably much more) for them to pay those bills. Unlike a Ponzi scheme, the idea that it will continue to attract new money to pay out existing claims is a realistic one. The real questions of its sustainability are a matter of specifics: is it collecting enough money to remain functional in the future, or is it outpacing the growth of the economy and the population?
You are forgetting one crucial point regarding the money supply. The US Federal Reserve increases the money supply, meaning some of the money is not really loaned, it just appears out of nowhere. At first glance this seems even worse: over the short term, the Fed changes the money supply to help the economy in whatever way it sees fit. But over the long term, the money supply increases to reflect economic growth. As new technology is introduced, more can be accomplished with the same labor and resources, and thus the money supply needs to be increased. Money is really just a convenient replacement for the barter system, so if there are more things to barter "for" (goods and services) then there should also be more things to barter "with" (money).
Also keep in mind inflation. The cost of goods and services goes up over time due to the inflation of currency, and so the money supply must also be increased so that those goods and services do not artificially increase in value, which would be very bad.
No, fractional reserve banking isn't a scam. A simple exercise: replace dollars with time. You're trading some time now for time in the future, plus a bit of extra time. This is only a problem if you promise your entire life away, which we've helpfully outlawed.
Once you realize that wealth is the result of human labor, and that money is simply a unit of account for it, it becomes far easier to see how simplistic models don't match reality.
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