Help me understand: Analogy to ponzi scheme

[tiger_handheld]

guys,

i've come across this analogy before, and from how i understood it - it describes how the world runs on credit. however, one of my collegues is trying to link this analogy to a quasi ponzi scheme. he has explained it to me - but i'm still not buying it. if any you see the relationship pls point it out:

cheers!

--

Analogy:

Subject ECONOMICS EXPLAINED
It's a slow day in some little town.
The sun is hot....the streets are deserted.
Times are tough, everybody is in debt, and everybody lives on credit.
On this particular day a rich tourist from back west is driving thru town.
He stops at the motel and lays a $100 bill on the desk saying he wants to inspect the rooms upstairs in order to pick one to spend the night.
As soon as the man walks upstairs, the owner grabs the bill and runs next door to pay his debt to the butcher.
The butcher takes the $100 and runs down the street to retire his debt to the pig farmer.
The pig farmer takes the $100 and heads off to pay his bill at the feed store.
The guy at the Farmer's Co-op takes the $100 and runs to pay his debt to the local prostitute, who has also been facing hard times and has had to offer her services on credit.
She, in a flash rushes to the motel and pays off her room bill with the motel owner.
The motel proprietor now places the $100 back on the counter so the rich traveler will not suspect anything.
At that moment the the traveler comes down the stairs, picks up the $100 bill, states that the rooms are not satisfactory, pockets the money & leaves.

NOW, no one produced anything...and no one earned anything...however the whole town is out of debt and is looking to the future with much optimism.
And that, ladies and gentlemen is precisely how the U.S. and Canadian Governments are conducting business today!
His Explanation:

I think the point that my controller and one of the presenters was making (as to how the world runs like quasi ponzi scheme one giant ponzi scheme) was this:

• I deposit (invest since I may gain some small amount of interest) my 100.00 into my savings account
• My bank loans that money to Bob for whatever (substitute “loans” for “invests” since the bank will get a return of principal and interest from Bob)
• Bob invests his money into new car, business, house, etc
• I lose my job and need to withdraw my money from the bank
• Bank repays my money with someone else’s deposit/investment
• and so on, and so on

And I think it all goes well, like it did for Madoff, until something upsets the apple cart, like a plunging economy and investors who have lost their money want to withdraw some of their “gains”. For example, I fall on hard times because of the recession as do many others. We all want are money from the banks (typical bank run situation) who is feeling the crunch from so many wanting to withdraw funds that have been loaned out. The bank goes to Bob and asks him to repay the loan. He also is in trouble because of the recession and cannot pay back meaning the bank can’t pay me back.

[ASG111]

Yes it's pretty much the same analogy because it's always someone else's money and no value is produced. essentially, the ponzi scheme works because the guy running it is always using new investor's money to pay the returns to the guys already in it. NOTHING is produced.

Same thing goes for banks and for us investors, the banks lend money to other institutions and businesses, and just using OTHER people's money to pay us back when we are in need. They create little value by charging interest to the borrowers, and this is partially the interest we receive from depositing our funds in the first place. The only difference is that in a Ponzi scheme it's very easy to see through it based on some analysis on how their returns are generated. it's not possible to incur 40% profits continuously... even if you're investing in some profound hedge funds. However, in banks, they have a very rigid process and banks definitely do have some huge suspend accounts where they can withdraw money when in need.

[misteranswer]

Uh, no one was in debt in this example.

It's easier to see how stupid this is if you shrink the number of participants to 3.

[taylor192]

Originally Posted by misteranswer

Uh, no one was in debt in this example.

It's easier to see how stupid this is if you shrink the number of participants to 3.

Shrink the participants to 3:
motel owner owes prostitute $100
prostitute owes motel owner $100
tourist leaves $100, motel owner pays prostitute, prostitute pays motel owner, motel owner returns money to tourist

Shrink the participants to 2:
motel owner owes prostitute $100
prostitute owes motel owner $100
they wipe out each others debt

Expand the participants to 4:
motel owner owes $100 to the bank
prostitute owes $100 to the bank
bank owes $200 to an investor
investor is owed $200

Yet where did the investor get the money from?

[taylor192]

Originally Posted by tiger_handheld

I think the point that my controller and one of the presenters was making (as to how the world runs like quasi ponzi scheme one giant ponzi scheme) was this:

• I deposit (invest since I may gain some small amount of interest) my 100.00 into my savings account
• My bank loans that money to Bob for whatever (substitute “loans” for “invests” since the bank will get a return of principal and interest from Bob)
• Bob invests his money into new car, business, house, etc
• I lose my job and need to withdraw my money from the bank
• Bank repays my money with someone else’s deposit/investment
• and so on, and so on

And I think it all goes well, like it did for Madoff, until something upsets the apple cart, like a plunging economy and investors who have lost their money want to withdraw some of their “gains”. For example, I fall on hard times because of the recession as do many others. We all want are money from the banks (typical bank run situation) who is feeling the crunch from so many wanting to withdraw funds that have been loaned out. The bank goes to Bob and asks him to repay the loan. He also is in trouble because of the recession and cannot pay back meaning the bank can’t pay me back.

The central component to all this is: money is just an idea, it doesn't really exist.

Think about this: There's only $1 in the whole world. There's only 1 product for sale in the whole whole, and I'm selling it for $1. Once sold, I now have that $1. If I produce a second product, and want to sell it for $1, where does another $1 come from?

The answer: inflation and interest. Obviously my example is too simple, yet with more people buying/selling products for $1, we're all effectively trading $1 and keeping no profit for ourselves. Thus the product has to increase in price after each sale, leading to inflation. Interest on loans works similarly.

The reason the world seems like a giant ponzi scheme is: what happens if deflation kicks in. Inflation and interest doesn't generate enough $$$ to continually buy more products, so people buy less, prices drop, and now your $1 is worth < $1. Your employer pays you less cause they are selling for less, and everything decreases in value.

Yet are you any worse off than during inflation? With inflation things cost more, yet you made more. In deflation, things cost less, so if you make less you're still living at the same standard. What's missing?

Oh ya: retirement. How do you retire on investments if your investments always suffer deflation? Why even invest if your investments are going to deflate? Thus the system has to always increase, or the system falls apart. This is why its a ponzi scheme.

So revisiting your example: everyone's debt is wiped out, yet no-one received any profit for their services, and they must work till they die.

[Gnomes]

My mind is blown. Thank you taylor and tiger for the insight.