- A company asks for an investment of money, with the promise of returning your principle as well as a guaranteed rate of return.
- Investors get confidence by seeing the returns, and if any of them tried to individually exit the investment scheme, the company would be able to pay them out.
- The company used that confidence in order to convince investors to leave their investment with the company.
- The company could only continue paying out returns for so long as enough money keeps coming in to cover the guaranteed rate of return.
- If every investor tried to take their investment from the company, the company would go bust.
From what I can see, a system that works like this falls into one of three broad categories, depending upon where the money comes from in step 4:
- If the money to pay returns to the investors comes in solely from new investors, it's a Ponzi scheme.
- If the money comes in through money being wisely invested, in other enterprises, at a higher rate of return, it's a bank using fractional reserve banking.
- If the money comes from poor investment strategies whose returns aren't enough to keep paying the investors, it's the U.S. banking system. It's still technically banking, but with the same end-game as a Ponzi scheme.
There is only so much money in the world, but the apparent amount of money increases linearly at best as money cycles back through banks. I say "at best", because if lenders lend money to lenders, then the increase in apparent money can take on some exponential characteristics.
Let's say a bank has $10,000 cash. It lends most of it out to someone. They pay other people to do something. Those other people put their money back in the bank. The bank lends that out, rinse, repeat ad infinitum. You potentially end up with people claiming that they cumulatively have millions of dollars, when there are only $10,000 in real, hard cash.
That's all fine as long as all the investments made by the banks to all those people, factoring in the money that the bank reserves, are aggregately positive. If they're not, however, you can see how just one bank could cause a ripple across an entire economy when the money cycles around so many times. And when lots of banks start making bad investments, you're gonna have a bad time.
But like a Ponzi scheme, when it all comes crashing down, the conmen still come out of it rich.