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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    Nobody pretended it can. The fact is, we are actually borrowing from the future. Therefore shortening our future. – Raskolnikov Jan 2 '11 at 14:58
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    I think this is a very interesting question regarding personal finance. It's a real shame that moderators use any excuse to dismiss a question as off-topic. I don't know about you, but I keep my money in banks, so I think understanding how they operate couldn't be any more relevant. – Igor Soarez Mar 5 '14 at 16:11
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    The only difference between a bank and a Ponzi scheme is that banks can print money to cover their asses. So that is why $10 today can't buy as much as $10 in the past century, and $10 in the next century would buy even less. Print, print, print. Once a Ponzi scheme gets the ability to print money too, it will no longer run out of funds and thus it stops being a ponzi and is now called a bank. – Pacerier Apr 28 '17 at 8:07
  • @Pacerier Banks can't legally print money. – user253751 Nov 20 '18 at 7:21

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 $1,000,000, 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 $10,000,000.) 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.

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    Not sure about why there's a downvote, but I added more information to clarify FWIW. – mbhunter Jan 2 '11 at 5:58
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    You get the downvote for "Social Security is a Ponzi scheme". Take out that irrelevant and contentious side-comment and you'd lose it. – DJClayworth Oct 4 '11 at 15:19
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    +1. And SS is a Ponzi scheme - how could anyone think otherwise? – Stephen Cleary Oct 14 '11 at 0:05
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    SS is not a Ponzi scheme, because it even about investment, it's an insurance vehicle. ("Old Age, Survivors And Disability Insurance"?) Specifically, it insures you against becoming old and poor. Part of the catch is if you die earlier, it doesn't spill over to your heirs. Either way, I think you're needlessly politicizing your response. – Darien Sep 30 '13 at 21:22
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    @Grade'Eh'Bacon : I think you'll find that the majority of Americans think that their SS checks come from the earnings of your previous contributions. Period. Many realize what you state, but the vast majority do not. It is a Ponzi scheme, regardless of whether it is acknowledged to be a Ponzi scheme or not. YMMV :-) – Peter K. Mar 9 '17 at 22:54

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.

  • Insightful point to link the amount of money available to the goods available. But then, fractional-reserve banking nevertheless requires the money supply to grow exponentially. Without the available goods growing exponentially - it won't - it remains unsustainable over time. With the peak of economic growth, how then is any bank going to avoid to default sooner or leater? – sibidiba Jan 2 '11 at 11:50
  • The exponent isn't a constant, fortunately, so I would expect it to shrink over time. A bad example: If you need $100 extra and the money supply is $100, then the exponent is 1.1. If you need another $100 extra with the money supply now at $1100, you don't use 1.1 because that would give you too much ($110). – Matthew Read Jan 2 '11 at 16:40
  • The other thing is that the amount the banks lend is limited as well. With a reserve of 10%, $10 is kept of $100 and $90 is loaned. Then of the $90, $9 is kept and $81 is loaned. Eventually you get down from dollars to tiny fractions of cents, and the banks don't bother loaning cents. Plus the total amount has a defined mathematical limit anyways -- I believe somewhere around 11x the original amount. – Matthew Read Jan 2 '11 at 16:55
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    Interest rates ultimately reflect the fact that it's possible to invest money in real stuff and get more back later because the investment was ultimately productive. If economic growth comes to a halt forever and investment opportunities disappear completely, then likely real risk-free interest rates will also hit zero. – GS - Apologise to Monica Jan 2 '11 at 21:59
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    @sidiba The exponent is not just smaller, it's constantly decreasing. The result is not the same as a true exponential function. – Matthew Read Jan 2 '11 at 23:57

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?

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    "A bank takes depositor's money and lends out to people who will pay it back". I totally disagree with you. Under the fractinonal reserve system, the bank most of the time is lending money which does not exist. The bank model is only sustainable because it is protected by law. I mean a normal person isn't allowed to lend what he does not owe, but a bank can do that under the fractional reserve rule. – MetallicPriest Mar 8 '12 at 16:26
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    Banks don't issue loans against nothing; as soon as you loan someone money, the borrower will spend it on something (e.g. a car or a house or whatever). The "creation of money" isn't because the bank is loaning from nothings, but from the fact that both the depositor and the borrower have this money at the same time. As for a "normal person", if your friend gives you $100 to store, you can in fact loan out $80 to another friend, with a 20% reserve. This will actually create $80, just like bank lending does. Sure, eventually Friend A will want his money back, but until then, there you go. – user296 Mar 8 '12 at 19:32
  • Read this, marketoracle.co.uk/Article20300.html. The fractional reserve banking certainly does not work like the way your are telling me. Its much more sinister than what you are saying. – MetallicPriest Mar 8 '12 at 22:08
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    @MetallicPriest - Honestly, this question was already at the fringe of what is topical for the site - this comment here is too far. Perhaps economics.stackexchange.com would be more willing to rip apart your conspiracy theories? – user296 Mar 9 '12 at 17:14
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    Rejoice. Conspiracy theories have gone mainstream. positivemoney.org – James P. Sep 30 '13 at 14:32

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.

Adam - $100


Here is a bank with $100 in initial deposits. Total money supply in this society is $100. (We assume there is no currency circulating, since you're interested in debt money.)

This bank lends out $90 to Bob at 1 year maturity and 10% APR. Bob spends this $90 with Charlie to buy raw materials. Charlie deposits $90 in the bank.

Adam - $100
Charlie - $90

Bob - $99

The money supply just grew from $100 to $190.

Bob does something with the raw materials and adds some kind of value, eventually selling the finished goods for $110. 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 $110 worth of goods from Bob. Let's say Adam buys $60 and Charlie buys $50 -- the actual amounts don't matter. Bob deposits this money at the bank.

Adam - $40
Bob - $110
Charlie - $40

Bob - $99

Still $190 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.

Adam - $45
Bob - $11
Charlie - $40
David - $4


Who is this David guy? He's the owner of the bank. He grosses $9 in interest from the loan to Bob, and he pays $5 to Adam as interest on Adam's deposit. The remaining $4 is the profit to the bank's owner.

Money supply decreased from $190 to $100 after Bob pays off his loan.

I realized after writing this, the one thing I left out is, "where does Adam get $100 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.)

  • Good example, though it works with 100% reserves. If you go higher with the loan-amounts you will discover that for Bob to sell his Product, somebody else has to take a loan to pay for it, which in turn has to create even bigger returns, which somebody has to pay for with lent money ... – Daniel Jul 30 '18 at 8:26
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    @Daniel With 100% reserves, Bob was not allowed to get his loan. – user253751 Nov 20 '18 at 7:25
  • @not_a_comcast_employee: Reread. Deposit is given at $100. With a 100% reserve requirement the Bank can lend $100. With a 10% Reserve requirement like currently in the US, the Bank could lend out $1000! – Daniel Nov 20 '18 at 9:22
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    @Daniel If the bank lends $100 then it has $0 left in reserves if Bob withdraws the money, or $100 reserves for $200 deposits if Bob keeps the money in the bank. Both are less than 100%. – user253751 Nov 21 '18 at 5:25
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    @Daniel Exactly. The bank is not allowed to give Bob that loan because it would put them below the reserve requirement. – user253751 Nov 21 '18 at 21:37

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.

  • There is no external source of money, fractional-reserve banking is a closed loop too. The economy being a "living thing" only implies that it could be changed. None of what you are saying contradicts my assumptions: fractional-reserve banking requires the gone-by exponential growth of the previous century. Sure it is the better the faster money circulates, but I'm still looking for an explanation how banks are possibly going to maintain liquidity if the economy won't continue to grow exponentially. – sibidiba Jan 2 '11 at 17:24
  • Just like you said for Ponzi schemes "the only source of the so-called interest on the money was the contributions of future investors", for fractional-reserve banking the source of interest is the future profit made by lending the investor's money - to the investors themselves! (Global economy is a closed loop.) Because of the size of the system this is quite indirect and works only until real economic output (oil, manufacture, services etc.) pushes the money supply on an exponential level. – sibidiba Jan 2 '11 at 17:34
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    As far as I know, we don't have trade relations with extraterrestrials, so characterizing the global economy as a closed loop is an odd notion. – duffbeer703 Jan 2 '11 at 21:38
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    +1 for "living thing" ... many of these notions that fractional reserve is some sort of con come from the fallacy that economies are a zero-sum-game, that for some people to get richer others have to get poorer. As you point out, economies grow because some people have the capacity to invent whole new professions out of nothing and can finance these ideas out of money borrowed from the fractional reserve. Obviously there is the downside if those new ideas prove unfounded, but we're all the living proof of the wonders of the upside. – Turukawa Jan 4 '11 at 9:57
  • "Fractional reserve banking makes the economy more efficient by putting capital that would otherwise be hoarded in circulation." What about credit crunches and squeezes ? en.wikipedia.org/wiki/Credit_crunch – James P. Dec 26 '12 at 9:23

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.

  • Your definition is interesting, because it seems to conflict with itself. If money is a unit of account for time, then how is it possible for banks to lend out "time" that they don't actually have in their vaults? – Mark E. Haase Oct 8 '11 at 2:36
  • Because banks have a buffer of equity they start with, and only lend out a fraction of their total assets under management, hence the term 'fractional' reserve. – jldugger Oct 8 '11 at 4:27
  • "Because banks have a buffer of equity they start with..." That sounds curiously similar to the notion of margin in trading. – James P. Dec 26 '12 at 9:24
  • "You're trading some time now for time in the future, plus a bit of extra time." In such a way that the unborn will have to pay off mounting excess ? Kicking the can much ? Whether it's a scam or not is irrelevant. It's just plain nonsense. – James P. Sep 30 '13 at 14:28
  • @JamesP. The idea to use time as a good is brilliant, while odd. It's valid only based on the consensus that time grows strictly in our appreciation. We do actually know - if it stops or slows down, we would not notice, and as we have no reason to assume it existed before big bang - why should it not? With that, it is guaranteed that it grows - we have defined away the risk that it stops growing and ends up less than at the start. Sounds contrived? But that risk is absolutely central. – Volker Siegel Jul 29 '18 at 11:33

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. alt text

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    You assume that the US government doesn't create its own currency in your answer. I explained to you in a different question thread that this assumption is incorrect. This renders the whole answer to be completely wrong (as all the rest in this thread). – littleadv Sep 30 '13 at 17:31
  • @littleadv. Of course. I forgot about US coins. That enormous quantity of money known as pennies, dimes, nickels, and quarters. – Muro Sep 30 '13 at 18:22
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    and $15T super coins. Oh, sorry, didn't want to make you feel uncomfortable. The point is that the US government can create its own currently, all it takes is an act of Congress. – littleadv Sep 30 '13 at 18:26
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    @james it's actually even more complex than that. Look at Muro's graph - its linear and not adjusted for inflation or devaluation. Is $30T today the same as in 1960? No. If the gas then was 25c/gal, and now is $4/gal - we have 800% inflation (in a very simplified approximation). So $30T now is $3.75T then. This makes the debt growths to be 300% and not 30000% as Muro tries to imply with his graph. Much less frightening, is it? – littleadv Sep 30 '13 at 19:36
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    There are many questions on debt that should be clarified. Can exterior debt be lumped together with promises like pensions and healthcare ? What exactly is interest being paid on ? Is all debt legitimate ? And more importantly, beyond which line can one say that the level of debt exceeds what the population should put up with ? It's a very grey area which isn't helped by political games. – James P. Sep 30 '13 at 20:14

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