Are big banks really part of a giant Ponzi scam?

My article that was originally published on OneIndia on 30th June, 2012 over here.

The big question

“So is the banking system really a giant Ponzi scam?” – This was the exact question that my fifteen year old friend asked me as I was explained the dynamics of the banking system to her. A strange question for a fifteen year old, isn’t it?

Image credit- OneIndia.in

What is a Ponzi scam?

In a Ponzi scam, the scammer takes deposits from people after promising a high Rate of interest. When old depositors want to withdraw money, the scammer simply gives them the money that is deposited by new depositors. This continues till everyone wants to withdraw at the same time and he has no money left to give anyone. The most famous scammer in the world-Bernie Madoff was sentenced to 150 years in jail for this role in a $65 billion Ponzi scam. So, is ourBanking system really a giant Ponzi scam? What is the connection between the banking system and a Ponzi scam? Read on to find out more.

The background: How money works

Bindu, my kid friend was interested in economics and asked me to explain how money works. I started off by telling her that money is just a store of purchasing power and that we started using paper money because it is impractical for us exchange goods and services directly (the barter system). For example, a farmer would find it very inconvenient to give a cobbler half a bag of rice in return for a set of shoes. I told her that paper money is essentially a promise by the Reserve Bank of India (with the full backing of the Government of India). For example, a Rs 100 note has value because the RBI promises to give the holder of the note, the value of 100 Rs. So, people use this money as a means to exchange goods and services. Therefore, the farmer in the above example would take paper money from the buyer of his rice and give money to the cobbler for shoes.

The role of banks

Enter banks into the picture and we now have a safe place for us to deposit our money. The farmer in the above example sells rice worth Rs 100 and decides to deposit it in the bank for safe keeping. At this point of time, the total money in our little system is Rs 100 (owned by the farmer and kept safely in the bank). The RBI and the government give banks the right to give loans to borrowers. They have to keep a certain amount of cash (from cash deposited by depositors) aside and can loan the rest to borrowers.

Image credit- OneIndia.in

Loans and money supply

This amount of cash they have to keep aside is determined by the Cash Reserve Ratio (CRR) set by the RBI. Let us suppose that the CRR is 20%. In our case, the bank which receives Rs 100 from the farmer has to set aside Rs 20 and can loan Rs 80 to borrowers.
An engineer now approaches the bank and asks the bank for Rs 80 as a loan for building a house. The bank agrees and gives the engineer Rs 80. The engineer promises to pay the bank back after 5 years along with interest of 10% per year. So, how much money is in the system now? The farmer still has Rs 100 in the bank (He can issue cheques for Rs 100 and the bank guarantees that they will be honored), the engineer has Rs 80. He can withdraw this amount or issue cheques against it. So, the total money in the system is Rs 180.

Something smells fishy

Upon hearing all this, Bindu said -“Wait, something is wrong. We had Rs 100 just a little while ago. How did this extra Rs 80 get created out of nothing? You just said thatMoney represents purchasing power i.e. goods and services. When there are no new goods or services being created, how can purchasing power get created? This is a scam, right?” asked Bindu.

Are bank deposits really money?

That was an excellent question. So are banks really creating money out of nothing? If so, does money still represent purchasing power? Let’s take one step back. Is there really Rs 180 in the system? Suppose the farmer wants to buy new equipment for his farm and goes to a blacksmith. The blacksmith gives the farmer his new equipment and asks for Rs 50. The farmer pulls out his cheque book and issues a cheque for Rs 50, which the blacksmith deposits in the bank.

This money is immediately deducted from the farmer’s account and is credited to the blacksmith’s bank account. The farmer now has Rs 50 in the bank and the blacksmith Rs 50(also in the bank). The engineer has by now withdrawn the Rs 80 (loaned to him by the bank) from his account to build his house. The money in the system is still Rs 180. The farmer was able to use his bank deposit to buy goods from the blacksmith. So, yes; bank deposits are actually money and the money in the system did actually grow from Rs 100 to Rs 180 out of well- pretty much nothing.

The very definition of a Ponzi scam

“We have a problem. If a bank can create money out of nothing, then this is a scam and I will prove it to you.” said Bindu. “What if the farmer and the blacksmith all want their money from the bank at the same time? The farmer and the blacksmith each have Rs 50 in their accounts- which they are legally allowed to withdraw at any time. So, the bank has to pay out Rs 80 in cash while it has only Rs 20(set aside as per the RBI mandate). So what will the bank give the farmer and the blacksmith? This is the very definition of a Ponzi scam!” trumpeted Bindu with an indignant expression on her face.

The lender of last resort

She had an excellent point, something that most people don’t think of. But she was wrong. The scenario that Bindu described is called a “run on the bank”. This can happen to any bank and it is for this very reason that the Reserve Bank of India acts as a lender of last resort. I said, “Relax! All the bank has to do in this case is to ask the RBI to loan it some money to pay the farmer and the blacksmith.” Bindu asked with a sarcastic expression on her face -“And where will the RBI get new money? Does it have a printing press where it can print new notes as it pleases?”

Yes, money can be printed
Well, I replied, “The RBI actually does have the right to print money at its discretion. So, in this case it will print money and lend it to the bank.”

“This just keeps getting better. First you said that any bank can create money from nothing and next, you say that the RBI can literally print money and loan it to banks. What happens to purchasing power then? How can money still have purchasing power if it can be printed at will while no new goods/services are created?” These are all excellent questions but I assure you that you have nothing to worry about. I will tell you more about how money still retains purchasing power despite the RBI’s ability to print money at will. I will also cover inflation, wealth creation and lots of other related topics in the next article in this series.

About the author
Ashwini Anand, CFA is the founder of  
India’s best investment portal for beginners – Investopresto.

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