Friday, September 9, 2011

Ponzi Schemes

The most notable exchange in the Republican debate from two nights ago was Perry standing by his characterization of Social Security as a "Ponzi Scheme". Is that a fair label? I'll give you the facts; you can decide. Is that good politics? Probably not, especially if it's ever separated from the words "... and we need to fix it now."

What is a Ponzi scheme? It's named for Charles Ponzi, an Italian-American swindler who set up a scam in Boston's North End promising to make massive profits arbitraging postal stamp markets. He signed up investors rapidly, told them (mendaciously) that they were making huge profits, and continued to sign up new clients at an astonishing rate. Most didn't withdraw their "profits"; those who did were paid out of the principle invested by new clients. The scheme continued for years.

There are many modern Ponzi schemes, most famously those of Bernie Madoff and Nevin Shapiro. The concept is simple: as long as more and more people buy in, the fund remains solvent and (very) profitable. When some hiccup interrupts the flow of new cash, however, the truth is revealed: there aren't any real investments behind those glossy statements.

Social Security, as originally proposed, was a pension fund for working Americans. They would pay in during their working lives, and - if they lived until 65 (at a time when the median lifespan was 63) - withdraw the investment later. It equalized payouts somewhat across people, so your money wasn't yours specifically, but the idea was that it would be in a Trust Fund for you when you retired.

That didn't last long. Within a few years of its creation, the accumulation of a large Social Security Trust Fund was blamed for the 1936-37 recession, and the fund was diminished in 1939. Since then, the system has principally relied on the current contributions of American workers to cover payouts to American retirees. There has been a surplus all along, but instead of saving the surplus, it has been borrowed by the Treasury. Thus, the Social Security Trust Fund largely consists of IOU's from other parts of the Federal Government.

Of course, unlike a swindler's scheme, Social Security enrolls everyone - workers can't just opt out if they realize they won't be paid later. And the process is transparent. We know that there's nothing in the Trust Fund, and we have for decades. The risk isn't that people will opt out of Social Security, or try to withdraw money early (you can't), it's that the ratio of workers to retirees will change drastically when the Baby Boomers retire.

If no reform is enacted, there are a variety of ways that Social Security could weather the storm. It could decrease benefits across the board. Congress could raise the retirement age to correct the ratio. Social Security could cash in its Treasury Bonds and force the government to drastically cut spending or raise taxes elsewhere. Social Security taxes could be increased sharply to cover the gap. Another possibility would be to sharply increase immigration of young workers from abroad.

What's sobering here is that Social Security isn't America's biggest worry. After all, the Baby Boomers will eventually die off, and the generations after them are in more normal proportions. Two other responsibilities of the Federal Government - Medicare and the National Debt - are projected to grow boundlessly. Nobody knows who's going to pay for those.

6 comments:

Matthew Baddorf said...

Very nice. Was the median age 63 at birth or at adulthood?

searchingforalethia said...

I don't quite agree. Social Security isn't a ponzi scheme -- it is more of a generational scheme where the younger generation supports the older generation.

Problem is that the BB is too big for one, and for two, the birth rate of the nation has been going down. Social security or not, if anybody older than a benchmark age wanted to retire, someone or something else must support them somehow. I'd much prefer a scheme based on investment rather than a pay as you go.

Chops said...

searching - I didn't take a position on whether SocSec is a Ponzi scheme or not, and I certainly appreciate the differences.

Matthew - I suspect that 63 was the adult life expectancy, not the at-birth life expectancy.

Raising the retirement age is the most obvious policy. It's already been raised once (to 67 for maximum benefits). It should probably inch up by another year every five years, or something like that.

Chops said...

Nota bene: back in 1996, Paul Krugman compared SocSec to a Ponzi Game that would "soon be over".

http://www.bostonreview.net/BR21.6/krugmann.html

Taoist said...

Hey Chops - Google randomly informed me you had a blog as well. I'll add it to my rss list.

--Ian

taoist said...

As for Social Security and Ponzi schemes, the reporters on NPR have informed me that social security isn't a Ponzi scheme because Ponzi schemes are illegal, while government has put a whole legal framework in place around Social Security.