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?

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 our banking 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.

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 that money 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.