Ponzi Finance Part 2

A ponzi scheme, as I described it last week, is destined to collapse because the earnings (usually non-existent) are outweighed by payments to investors. The early investors are paid by payments made by later investors (with the scammer, of course, taking a cut as well). This can go on for quite some time, as long as there is an infinite supply of new investors with new money, and there is a shrinking supply of old investors taking money out. Once the inflow of new money decreases to the point that money leaving exceeds money coming in, the scheme is exposed and collapses. But as long as that new money comes in, schemes can go for years, even blatantly under the noses of regulators (the Madoff case in particular comes to mind) before unraveling. So, what we have is a pool of money with an outflow, to investors thinking they are "returns" on their investments, and and inflow of new investors; money, As long as the inflow is greater than the outflow, all is well. But since there is no real "return" on the investment, and there is not an infinite number of new investors waiting to put money in,  the scheme will eventually fail.

That is a basic description of a ponzi scheme, and while I was thinking about it, it struck me that there are several similarities to fractional reserve banking (I gave wikipedia's definition of both in a post last weekend, but here and here are links to them). Actually, instead of similar, they are more like mirror images.  A ponzi requires a constant inflow of money, while fractional reserve banking requires a constant outflow of money. In a fractional reserve system, banks are able to create money, basically out of thin air, in the form of credit, and profit off the interest on the balance paid back. In such a system, if the outflow exceeds the inflow, the system is able to sustain itself. It is when there are either no more able borrowers, or those who are able borrowers no longer want to borrow, that the system gets into trouble. In order to sustain itself, it has to find new borrowers, and this is what we have been seeing for the last 20 years or so. The level of debt, both private nad public, has reached a saturation point, and the only way the system could expand was the pool of borrowers, thus the "sub-prime"mortgages and it's variants, along with such things as credit cards being sent to your dog, 60 month (or longer) car loans,, home equity lines of credit, etc. At some point there is a "tipping point" where the system can no longer sustain the debt it has created. The result of that is defaulted loans, bank failures (as outlined in my earlier post tonight), and loss of confidence in the banking system. The final act, a run on the banks and the failure of the banking system, was the root cause of the Great Depression, a fate we have so far avoided, but it hasn't been without it's costs. there has been a massive shift of private debt into public debt, and while it has saved thee banking system for now, in the long run it threatens the stability of governments all over the world.

I hope I have not over simplified this,  as I am no expert on the subject, but the more I delve into it, the more it seems that what happened in 2008-2009 was inevitable, and there can be a case made that it was no accident, and the more it seems likely it will happen again. I plan to do more on this in the future to see just how far this rabbit hole goes.