Is Banking A Ponzi Scheme?

A common argument* (to the effect that banking is a Ponzi scheme) is considered below**

[* Note: The argument considered is the one (imperfectly expressed) below. There may be other arguments claiming that banking in general, or in certain circumstances, is a Ponzi scheme, which may be true, but are not considered here.]

[** Second Note: I'm no longer sure that the argument is false. Although 'Ponzi scheme' is pretty imprecise word. The aspect I'm not sure about is that banks may have a monopoly over 'created' money and there may be the potential for a sort of 'short squeeze' on bank deposits/cash.]

When the rate of interest charged by banks on loans is greater than that charged on deposits, does banking constitute some sort of Ponzi scheme? Here is the argument:

Imagine a desert island consisting of one guy and a bank.

There is a certain amount of cash in a desert island economy (lets say £100) and it belongs to the bank. This is helpful because then the bank needs capital and liquidity to make loans and the guy wants some money. Let's say that banks need to have both capital (net assets) of £100 and liquidity (cash) of £100 in order to loan £1000 (both a liquidity requirement of 10% and a capital requirement of 10%).

So the bank on a desert island has £100 in cash. Through the wonders of fractional reserve electronic banking it can lend someone £1000 as an electronic deposit at an interest rate of (say) 10% per year. So long the guy doesn't want to withdraw this money in cash (aha the bank has only £100 in cash, so that would be impossible!) then the bank can create a deposit of £1000 and a outstanding loan of £1000. Let's say the deposit pays 5% per year from the bank to the guy and the loan pays 10% per year from the guy to the bank.

This guy is stupid and does nothing with his deposits. After a year, the deposit in the bank expands to £1050 and the loan outstanding amount expands to £1100.

The bank wants the principal plus interest back (£1100). But the guy has only £1050 of 'money' (deposits). In fact, since in our thought-experiment world, outside the bank there is only £1050 of money in total in the economy! So when all the debts are canceled by the deposits the bank is still owed £50. Money conservation (so the argument goes) implies that there is not enough money to pay back the bank, because amounts outstanding on the loan increase faster than outstanding amounts on the deposits!

Hence, banking requires an ever increasing amount of new money created to pay back the old.
So someone has to default. More debt is required to keep the thing going!! A Ponzi scheme!!

This is a very simple argument. However, is it true?

Is it true for any profitable institution? Say a supermarket? A supermarket makes profit - more money comes in than goes out. What does it do with the profit? Is it recycled, or do all the bank notes always end up with the supermarket? Usually the profit is either distributed to shareholders or kept as assets on the supermarket vault. Does any profitable institution eventually suck the whole economy dry of money? Or is that money usually given back to shareholders or used to buy real assets?

Is it the same with the bank? Can't the desert island bank just pay back it's shareholders, or buy some real estate. In this example, the profits from the rest of the economy are ploughed back to the bank, and the bank gets richer.

So in the original situation, the bank uses it's £50 profit to buy the guy's garage (in the open market), paying off his debt. Then there are no outstanding debts. Of course, since the bank made some profit at the small guys expense, the garage ownership got transferred from the small guy to the bank. The bank has ended up one garage richer and the guy has ended up one garage poorer. The bank makes the new asset cancel the existing debt obligation.

Now let's say that the man is poor, with no garages or other assets to sell. In that case he goes bankrupt and defaults because he does not have anything to pay back the bank. The bank has to write off the asset and the bank loses the excess asset that it thought it had.

So what happens depends on whether there are assets to transfer in exchange for the debt. But there is no 'money conservation problem'. There is only a default problem if the poor guy has nothing to sell to the bank, in which case the poor chap is bust. Otherwise the bank gets more stuff (not money).


Let's introduce growth into the economy.

Let's now say that the guy is a builder; he started off with one house with garage; however this time he does not just sit on his electronic money. This builder instead transfers £1000 in electronic money (deposits) to a brick supplier who supplies bricks and the builder builds a second house plus two sheds. He sells the second house (plus shed) to the brick supplier for £1050, leaving him with a second shed worth £50.

What is the financial situation?
The brick supplier starts with zero, and then received £1000 of deposits (in exchange for the bricks). This grows into £1050 of deposits (in the bank), and then is paid back to the builder leaving £0.

The builder starts with £0, gets a £1000 deposits from the bank in exchange for £1000 of debt. He pays £1000 of deposits to the brick supplier. After 1 year he receives £1050 of deposits back from the brick supplier. He then has £1050 of deposits and £1100 of debt. He uses the £1050 deposits to pay off £1050 of debt, leaving himself with £50 of debt (ie obligations to the bank). He then sells the second shed to the bank for £50 in cash. He deposits the £50 cash at the bank, paying off the deposit. The final situation is exactly the same as before, except that the bank now has a shed.

This is productive economic growth and is not a problem, albeit one where the product of the growth goes to the bank in exchange for finance.

There is no Ponzi scheme. There is a certain amount of financialization - transfer of assets to the financial sector, but no shortage of money.

The mistake is to see the obligations to the bank - and in particular the remaining obligation £50 to the bank as being a bit of 'negative money'. It is not. It is an obligation to the bank. This obligation can be paid back with any sort of asset, not necessarily a bank deposit or cash. The bank creates a net obligation to itself of £50 through it's hard-nosed practice of charging more interest on its loans than it donates on its deposit (and - we might add - it has a lot of sometimes free implicit government support). But it does not induce a money shortage. It just achieves, at the end, more of the assets in the economy to itself in exchange for being profitable.


Tim Joslin said...

Hmm... In this example the bank is really no different to any other enterprise. Instead of loans and deposits I could simply be making widgets for $1000 and selling them for $1050. I don't see why anyone would describe this more general case as a Ponzi scheme either (a Ponzi scheme is when you pay depositors' interest - or investment income as alleged in the cases of Madoff and Stanford - from the principal of subsequent depositors/investors, which doesn't happen in these thought-experiments). Anyway, a strong argument why you can't eventually control the whole economy is that eventually depositors do default (as even the mighty Citibank and BofA are now only too well aware), eventually currencies become worthless, und so weiter. At least, that's what's happened throughout the whole of human history until now.

Tim Joslin said...

Further to my previous comment, where I expressed some puzzlement as to why anyone would describe your hypothetical bank as a "Ponzi scheme" (it doesn't meet the criteria), I think too much weight is being given to the rules the hypothetical bank (or any other) is operating under. The business model is: lend $1000 in the hope of getting $1100 back; not: lend and automatically get $1100 back. Repayment of a loan is subject to human behaviour, not natural laws. If a bank lends $1000 and hopes to get $1100 repaid, giving a $50 profit after cost of capital, also $50, there are a range of possible outcomes (the risk-adjusted value of the loan even when first made is not as much as $50, i.e. $1100 less $1050, though hopefully it's more than $0). The bank could receive nothing back (full default), up to the full amount lent plus interest (early repayment including full interest would imply even more than $50 profit, of course!). But the bank only makes a profit if it manages to get at least $1050 back. If there is insufficient money in the economy, and, noting your example, nothing the bank wants in lieu of cash, the bank simply can't make a profit - a point those sub-prime lenders might have taken a moment to think about before advancing those $trillions. On average, over a long period of time, banks do well to break even! As I said before, in the long-run all banks die, as defaults exceed their capital (especially if they lend to governments, funnily enough!).

I think we do have problems with the money supply, not because your regular banks are running Ponzi schemes or any other kind of fraud, embezzlement or outright theft as many seem to believe just now (I really don't think accusing bankers of all manner of crimes really gets us very far, to be honest), but because of the way the leveraging process behaves if no regulatory effort whatsoever is made to control it, compounded by the fact that trade deficits have been allowed to produce an excess of money in deficit countries in particular - I simply don't see how asset bubbles are avoidable given the recent sustained level of trade imbalances (accompanied by the nonchalant, hubristic regulatory behaviour we've seen for the last decade or so). E.g. see the recent post on my blog:

TheClimatePhilosopher said...

Further comment from a correspondent:

I argue that money creation as interest bearing debt involves:

1) Unexpectedly high default rates

2) expansion of debt faster than money to avert collapse in an
unexpected wave of defaults. This necessarily involves progressively
falling credit quality or

continual money "printing"/creation not as debt or

rapid bursts of money "printing"/creation not as debt resulting
in bursts of price rises or hyperinflation.

3) real interest rates which are generally negative, leading to
chronic malinvetment

4) economically loss-making banks (ie banking sector makes a negative
overall contribution to the economy.

Your argument in the blog shows one loan being made and being defaulted
on! This is compatible with claims 1, 2.

Your comparison with the supermarkets is completely spurious, since the
supermarkets collect money from customers and hand it all back to employees
and shareholders. Sometimes they store it for shareholders for later.

Robin Smith said...

Thanks for this interesting blog. I'm trying my best to understand it. Yet in the first few paras you mix the use of the terms money and capital. You are going to need to define both terms before I can begin to understand your story. i.e., what is capital and what is cash and what is money in the context of your story please.

I realise it is a hyopthetical analysis, yet its not one I can imagine even then. If the guy was shipwrecked and he found £100 on one hand and just enough food and water to live in the other, which do you think he would consider important. The wealth of course, which is the sustainance. The money is not worth anything. If you could frame it in such a way as to make the money have meaning then that would help me understand.

TheClimatePhilosopher said...

@Robin please see my latest post

I agree that cash isn't the first thing on the guy's mind if he's been shipwrecked - in fact there's no need for it at all if there is nobody else on the island. So the example is a little contrived. But the point is you have to create the most simple thought experiment in order to understand something fully. I'm interested here in the financial part of the economy and adding more people to the story would make it unnecessarily complex! Think of it as a thought experiment on finance; it's not a morality tale about the 'real' economy.

TheClimatePhilosopher said...

@ the correspondent (comment 3) see the following post. I argue that in order for money to be conserved, some of the cash in the bank needs to find its way to the real economy.

This is similar to the approach argued for by Tim Congdon in the FT today.

Robin Smith said...

Are you suggesting that I accept that a thought experiment is still valid when it has no bearing on the real world? Thats fine if you dont expect the real world to respond in kind. But then what value has this? And why are you so afraid of thinking about the real world, its much simpler to do that. No need to worry about unravelling the mysterious use of economic terminology until you can help me with this one first.

TheClimatePhilosopher said...

@Robin; basically a thought experiment is useful because it is a simplification of the real world. It's possible to imagine a 'real' economy going on (as I do with the brick & houses economy). So if you want to understand a real economy, then go to the second, more complex example in this post.

TheClimatePhilosopher said...

@Robin, a second clarification: this post is about the 'financial' part of the economy (ie the banking system). This has an important link to what I'm going to call the 'physical' part of the economy - production of goods and services. This post illustrates first the financial part of the economy in isolation and then the financial part of the economy in conjunction with the 'non-financial' part.

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