The Greatest Ponzi Scheme of All

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Bernard Madoff swindled clients to the tune of $50 Billion in the recently revealed “ponzi” scheme. How could this have happened? How could supposedly sophisticated investors have been duped on such a grand scale?

It seemed that either no one was watching or the warning signs went unheeded. But you couldn’t blame them, nothing like this had ever happened before. Or had it?

Most people understand that a ponzi scheme is when money from new investors is used to pay earlier investors, making it look like they are getting a great return on their money. Eventually there are not enough new investors to pay off the earlier ones and the scheme collapses. It was named after Charles Ponzi, who perpetuated just such a fraud in the 1920s.

Madoff was the former head of NASDAQ and highly respected, surely being scammed by someone like him was unprecedented. Not exactly. In the 1930s the former head of the New York Stock Exchange, Richard Whitney, attempted a similar scam. So it has happened before and will probably happen again. People believe things that they shouldn’t and succumb to greed and then they wonder how it could happen. While Madoff’s scheme is one of epic proportions, there is an even bigger scam being pulled off on a daily basis.

The Big Lie

If there is an even bigger swindle going on, why doesn’t someone tell the Government? They already know. If they already know, why don’t they stop it? Because they’re the ones who set it up in the first place. And no, I’m not talking about Social Security even though you could compare that to a ponzi scheme. I’m talking about fractional reserve banking. Huh?

Once upon a time banks would accept money from depositors and pay a certain rate of interest. It would then use the money to provide loans at a higher rate of interest. The difference between the two interest rates, the spread, was the bank’s profit. In fractional reserve banking the bank may, for example, loan out $10 for every $1 deposited with the theory being that not all depositors would demand their money back at the same time. So, in essence, the banks lend money that doesn’t exist. One of the functions of the Federal Reserve is to set the reserve requirements for banks. This is essentially telling them how much “fake” money they are allowed to lend out.

In our system of fiat currency the money has value only because you believe it does. There is no gold, silver or anything else backing the money except for the “full faith & credit” of the U.S. Government. A ponzi scheme falls apart when there is no new money to pay the earlier “investors” and everything collapses and the scam is exposed. A fiat currency collapses when people stop accepting its value, such as in times of hyperinflation.

Keep it Legal

So if you have dreams of running your own ponzi scheme, do it the right way. Get yourself chartered as a bank and lend out money that doesn’t exist. Instead of wearing leg irons and prison stripes you can be called a great bastion of capitalism. Heck, you might even qualify for a Government bailout someday.

Banking establishments are more dangerous than standing armies.
Thomas Jefferson

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.