Monday, November 24, 2008


I'm still listening to the Planet Money podcast on NPR, and this week they'll be well worth listening to. They're doing an entire week's podcasts around the theme, "What is money?" And listening to today's interview with Niall Ferguson, the author of The Ascent of Money (a book I think I have to read), I began to get the weirdest question about the banking system. How is the banking system like a Ponzi scheme?

First, what is a Ponzi scheme? A Ponzi scheme is a fairly common scam (Colombia just had a bad one) which works because of the human urge to get something for nothing. The schemer (the original one actually was named Charles Ponzi) offers to double your money in six weeks, or some other outrageously high interest rate. So you and all your friends give him a lot of money; and six weeks later you get double the amount back. So you give him more money. What you don't realize is that the money you got back after six weeks came from the people who invested with him at 5 1/2 weeks. The Ponzi schemer keeps paying people back for some time, because satisfied customers are the best advertisement to bring in more investors. (If you have to invest in a Ponzi scheme, be one of the first. And don't reinvest.) At some point he judges that he has as much as he can pull in on this round, and he puts it all in a bag and skips town.

The point that Ponzi schemes have in common with banks is: they're both based on trust. You give your money to a bank, and you trust that when you want it back you can get it. And when depositors stop trusting that the bank will give them back their money when they want it, there's a run on the bank. Because at any given time, the bank doesn't have all the money that was deposited with it. It's loaned it out, and is collecting interest on it. (More interest than it's paying you.)

So is the main difference between a bank and a Ponzi scheme the fact that the bank actually intends to give you your money back, on demand, and the Ponzi schemer doesn't? Because in both cases, when you get money back, it isn't "your" money (in the sense that it's the same dollar bills you gave them earlier). It's money that someone else just deposited, which hasn't been loaned out yet. And when that person writes a check, the money that changes hands came from yet someone else.

Money is based on trust. Money is not the dollar bills in your pocket; it's your confidence that when you give enough of those dollar bills to the barista at Starbuck's, the barista will give you a latte in return. And it's Starbuck's confidence that when it gives those dollar bills to the barista as a salary, he'll be able to spend them on rent.

1 comment:

  1. Money is so simple compared to investment banking.

    How about I sell you an insurance policy against the likelihood that the people who hold a batch of mortgage paper will actually be able to collect? We trust each other. Besides, everyone knows real estate is the best investment there is. So what if the mortgages upon which the mortgage paper is based are unsustainable? Well, then, that's what I sold you the insurance policy for, right? But wait!, if all the insurance paper I sold you comes due at once, what happens? What if a lot of the mortgages which were batched together and traded and split up and spun around the market with dizzying speed, suddenly went into default? Oh-oh. Now we're in a whole new ballgame. Just how much were those batches of mortgages worth, now that many of them were in default or repossession? No one knows, because it's even become difficult to determine who actually owns (is responsible for) those mortgages! So all these obligations get "floated"--that is, not called, or actually collected. IOU's sitting in the locked desks of accounting departments in big banks (actually, they're all in computer files). No one wants to talk about how much liability they're holding, but, inevitably, word leaks out. Citibank has a trillion dollars in uncalled default, and they won't show the books to anybody, including the Federal Banking Regulators.

    Why give these folks money? Will that save any of the crumbling mortgage contracts across the nation, the phenomenon that is causing this crisis? Not likely.