A couple of years ago, I claimed on this blog that Social Security is a Ponzi scheme. Various commenters objected but didn’t persuade me. This week, John Seater, an economist whom I respect a great deal, wrote that it is not a Ponzi scheme. He’s given the best argument I’ve seen yet for that view. I’m still not persuaded. Seater wrote:
Medicare is neither a chain letter nor a Ponzi scheme. Those are closed-loop circular arrangements in which the scheme eventually comes around to the same people who already have paid into it and asks for more money than those people got. Medicare and Social Security are open-loop intergenerational transfers in which the person receiving benefits now is never asked to pay in the future because he is dead by then.
Both Medicare and Social Security in principle could remain solvent, in contrast to chain letters and Ponzi schemes, which necessarily cannot. In practice, Medicare and Social Security were undone by two unrelated things. First, the politicians saw they had vote-buying goldmines in both programs and kept ramping up the benefits associated with each, necessarily ramping up the costs, too (but of course politicians never talk about the costs of anything). Second and more important, there was a major demographic shift in the form of a huge drop in the number of children born to fertile couples, leaving far fewer young people to pay for the benefits being received by old people. That was bad luck as far as financing Medicare and Social Security was concerned, but it was in no way a necessary outcome of either program.
It’s not necessarily the case that Ponzi schemes must circle around to the original people who invested in them. If the scheme offered modest enough returns and spread slowly, it could last forever in a country with a growing population. Therefore, Ponzi schemes, contra Seater, could remain solvent.
I’m back to the point I made in my original post, a point I quoted from my book, The Joy of Freedom: An Economist’s Odyssey:
There are two main differences between Ponzi’s original scam and the Social Security system. The first difference is that Social Security is run by government and, whatever its constitutionality and its questionable ethics, is legal. The second difference follows from the first: Whereas Ponzi had to rely on suckers, the government can and does use force.
READER COMMENTS
kzndr
Jun 29 2011 at 1:06am
Wouldn’t another relevant difference be that ponzi schemes rely on fraud? Perhaps you could argue that politicians have been dishonest about the costs of Medicare and Social Security, but the framework of the programs and the details of the funding are there for everyone to see. And while participation in them is mandatory as long as they are the law, voters are free to vote in politicians who would dismantle them (as difficult as that may be, practically).
PrometheeFeu
Jun 29 2011 at 1:18am
I think it is pretty clear that Social Security is a Ponzy scheme in the sense that the latest participants pay for the earlier participants and that the later you participate, the lesser your return. (until your return becomes negative) This is why I don’t participate in Ponzy schemes and why I don’t try to time the market. You just can never know what part of the scheme you are at. Of course, I have to make an exception when men with guns force me to participate in said scheme. Ergo, I pay into Social Security.
Charlie
Jun 29 2011 at 1:41am
I remember studying in grad school these old papers that were Ponzi schemes that made everyone better off. http://128.83.172.192/~cooper/og09.pdf
Brandon Berg
Jun 29 2011 at 2:21am
I think that the key thing that distinguishes a Ponzi scheme from the sort of legitimate pension program that Social Security’s advocates would like us to see it as is that a Ponzi scheme cannot sustainably work as advertised.
Social Security fails on this criterion. The tax rate has increased sixfold since the program’s inception because politicians could not resist the temptation to promise better returns than could be sustained at contemporary tax rates. The only reason they haven’t had to raise tax rates further in the last 20 years is that the Baby Boomers have been in their peak earning years; once they retire it will again be impossible to pay out the promised returns without raising taxes.
Social Security cannot sustainably work as advertised, ergo it’s a Ponzi scheme.
Alex Godofsky
Jun 29 2011 at 2:34am
What’s the point?
I mean, really, Social Security is Social Security. Everyone knows how it works. Arguing whether it’s a Ponzi scheme is just an argument over how to define a Ponzi scheme. The outcome of that argument has no bearing on whether the program is itself good policy.
Eddy Elfenbein
Jun 29 2011 at 6:23am
No Ponzi Scheme can last for 75 years.
Ponzi Schemes are born to fail. Social Security is a government-run transfer payment program. It can be run poorly or it can be run well. There is no inherent reason why Social Security must fail.The same cannot be said of a Ponzi Scheme.
John Goodman
Jun 29 2011 at 6:37am
David, you were right the first time.
Both Social Security and the chain letter can survive only if they find new victims — people who will never volunteer to be vicims if they know all the facts.
Josh H
Jun 29 2011 at 8:12am
This is an interesting characterization of a system which has been abused and neglected for entirely too long. The premise that a social security trust fund exists is a joke in light of the national debt of this country and the wasteful spending of monies borrowed against the social security trust fund. The way in which the system is mismanaged creates a negative externality in my view. Social security withdrawn from citizens and businesses is merely an underhanded additional tax for which the government has an obligation to fulfill that it cannot under the current fiscal circumstances. Either the system needs to be reformed in a way where the funds are legitimately set aside or we need to abolish the entire social security tax. The reason for this is that taxpayers are always going to feel a sense of entitlement when they pay into a system which promises a benefit whether they possess a financial need to receive the benefit or not.
I propose a quasi defined benefit/defined contribution plan (vis-à-vis privatization of social security). The defined benefit segment would require those who have the economic means to contribute to a government controlled account which is set aside to provide an annuity of income at retirement if the individual has inadequate assets and income to support basic needs. There would be no reported account balance to the individual. It would merely be looked upon as a tax, much like social security, for which the individual receives a commitment that he or she will receive enough income during retirement to satisfy basic needs, not vacation money. The key here is that an actual account (pooled with other taxpayers) would exist possessing the money to fund this commitment. Should the individual at retirement not qualify through a means test, these monies would go towards funding those who were not able to pay into the plan during their lifetime but are drawing on this benefit.
The taxpayer (or participant) would then have the opportunity to fund the defined contribution portion of the plan up to a certain maximum. Again, these dollars would be placed into an actual account which would report a future annuity amount to begin at retirement and terminate at the participant’s death. A cash value would exist with this plan during the lifetime of the participant which benefactors would receive at death. In order to incentivize individuals, these dollars would go in pre-tax and would come out tax free, hence the need to set caps on contributions.
Our current mismanaged social security system isn’t providing the minimum which citizens need in order to provide for survival during retirement. Instead the system is setup to augment a lifestyle. If you remove the entitlement which the system has set in the minds of participants, I feel the system could become sustainable. The phase-in of such a system would be complex and would require political leaders to grow some gonads and have the courage to stand up to their constituents and enact real and meaningful reform.
Joe Cushing
Jun 29 2011 at 8:17am
My understanding of a Ponzi scheme is that it is not a closed loop–that the scheme works by constantly bringing in new people to repay the earlier people. I think your economist friend missed that. What you quoted from your self as the main differences on the bottom are important. The force involved is very important. Without force, social security would have already fallen apart like all other Ponzi schemes. If you removed force, I and millions of others would immediately stop paying into the scheme. Like most other government programs, it’s force that gives it legs where a private program like it would have failed a long time ago. I wish I weren’t forced.
Don Levit
Jun 29 2011 at 9:18am
Maybe we should reframe the question to ask “Is Social Security performing as it was intended to do?”
Roosevelt intended for tne program to be self supporting, with no use of general revenues.
That has been the case for current beneficiaries, who get paid from current payroll taxes.
It is the future beneficiaroes who have to use the trust fund who are being paid with general revenues, not payroll taxes.
Actually, the future is here, in that the trust fund is already being utilized, in that current payroll taxes are less than what is being paid out to current beneficiarioes.
Social Security is completely pay-as-you-go.
Without a reserve for future beneficiaries, it may not be considered a ponzi scheme, but it is a dangerous way to run an insurance program that was intended to be self supporting.
Don Levit
The Engineer
Jun 29 2011 at 9:41am
Does the equation that Social Security uses to define benefits matter?
If SS indexes future benefits from current wages plus inflation, and wages increase faster than inflation, is it then sustainable?
Have we gotten into this mess simply because the Carter administration indexed benefits to the rise in wages?
E. Barandiaran
Jun 29 2011 at 10:03am
I suggest that you and John Seater bet on which of these two systems will require a default first:
1. The U.S. Federal government’s system of issuing bonds to finance its deficits.
2. China’s national government’s system of using people’s deposits into state banks to finance its deficits.
If John Seater is right, then the Chinese system will collapse first. If you are right, then the American system will collapse first.
Indeed one can argue that the American system may collapse as soon as August 2, 2011, and therefore the bet doesn’t make any sense. Sorry, too late to change history.
The purpose is to ignore the rhetoric of what a Ponzi game is and to focus on both the high levels of government spending and the costly financing of this spending. FYI, the relevant level of government spending is much higher in China than in the U.S., but most likely the Chinese government owns a much larger amount of marketable assets than the American government. Remember that the beauty of a Ponzi game is how little everyone (including Ponzi) knows about when it will collapse.
Bob Murphy
Jun 29 2011 at 1:11pm
I agree with you David. When I read his quotation I thought, “It’s just an issue of timing.”
foosion
Jun 29 2011 at 1:18pm
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fundamentalist
Jun 29 2011 at 2:54pm
SS is a Madoff scheme.
Bruce Beckner
Jun 29 2011 at 4:01pm
A Ponzi scheme must fail; that is its nature. I don’t think Social Security’s nature is that it must fail. If the ratio of workers paying in to retirees drawing benefits were constant, the system could work indefinitely so long as the amount of benefits was matched to the amount of contributions (and that amount, once set, could remain fixed). While everyone points to the imminent retirement of the Boomer generation as the problem, I submit that is the wrong way of looking at “the problem.” Rather, it was the large — and for many years, growing — number of Boomers paying into the system supporting a relatively small number of retirees that allowed the politicians to keep enriching benefits (beginning with inflation indexing of benefits. . . without indexing contributions to inflation) without setting off any fiscal alarms. With the exact opposite of the situation that has existed for the past 30 years in the offing (decreasing numbers of workers paying in, relative to the number drawing benefits)the mis-match between per capita contributions and per capita benefits is inevitable.
If there’s any dishonesty here it is in the preservation of the public fiction that somehow the system has been “saving up” to pay future benefits (remember Al Gore’s “lockbox”?) when, in reality, excess Social Security contributions have been partially financing federal government deficits. The IOUs between the Social Security system and the federal government are, somehow, going to have to be refinanced beginning on the day when benefit payouts exceed contributions.
Miss Capri
Jun 29 2011 at 5:33pm
Actually chain letters do victimize the same people over and over, not the snailmail, envelope-stuffing variety so much, but those dang internet virals! Social security is meant well. Ponzi scheme is just a fraudulent means for some greedy mook to get rich off other people and leave them broke. In otherwords, it’s robbery.
Arthur_500
Jun 29 2011 at 8:51pm
I believe it is a Ponzi scheme in that investors (we the taxpayer) pay into the plan with an expectation of return. Then the politicians take our investment and spend it on something else.
Why is this different than Madoff buying things for himself and his family with investor funds?
Madoff paid off those who wanted out so they were ‘made whole.’ However, social security is backed by IOU’s and this ponzi scheme is unravelling.
Mr. Geitner said if we don’t get to borrow more then we won’t be able to pay social security. Of course then he also says the fund is solvent.
Why can’t we treat politicians the same way we treated Mr. Madoff or, for that matter, Mr. Ponzi?
MattW
Jun 29 2011 at 10:28pm
A Ponzi scheme pays out not from any return on investment, but from new “investors” adding their money to the scheme. I’m sure if someone really wanted to they could find a way to justify SS and Medicare as some kind of investment with a return thus making it a non-Ponzi, but libertarians wouldn’t find that convincing.
I could set up a Ponzi scheme that would last forever as long as everyone followed the same basic rules that SS and Medicare follow: I get someone to invest a dollar in me, and he has to wait 20 years before he can ask for an investment of $2 (or whatever the equivalent of $2 is that year adjusted for inflation) from someone else, and so on. That way everyone gets a 100% return.
There’s a never-ending supply of people if the time horizon is long enough, which it is with my scheme and with entitlements. I still don’t thank that disqualifies them as Ponzi schemes.
rhhardin
Jun 29 2011 at 10:31pm
Social Security is an inflation adjusted annuity that insures you against outliving your income.
The average person can save for an average retirement, but not for the longest possible retirement.
SS works by covering that gap, using the money of people who die sooner to pay people who die later.
The only flaw is that the retirement age is set wrong.
Just raise it to whatever balances the number of workers and benefit-receiving retirees.
If you want to retire younger than that age, bridge the gap on your own dime.
I don’t see the ponzi structure.
John Seater
Jun 30 2011 at 6:50am
Sorry to be late in replying. I’ve been taking a woodworking class at Roy Underhill’s Woodwright’s School all this week and have not been keeping up with anything else.
David is right that a Ponzi scheme can continue if its implied rate of return is lower than the population growth rate. However, my point was not about the fine details of Ponzi schemes but rather that Medicare and Social Security schemes are not Ponzi schemes. David’s argument has no relevance to that and does not invalidate what I said.
Suppose there is no population growth, just birth and death. A Ponzi scheme necessarily will fail, though the individuals who bear the loss may not be the same as those who got the initial benefits. Social Security and Medicare can continue fully solvent forever and even *can improve social welfare*. See Peter Diamond’s famous article on the overlapping generations model (for which he really should have gotten the Nobel prize, in my opinion).
Social Security and Medicare simply are not Ponzi schemes.
Don Levit
Jun 30 2011 at 11:40am
Bruce wrote:
Excess Social Security contributions have been partially financing federal government deficits.
The IOUs between the Social Security system and the federal government are, somehow, going to have to be refinanced beginning on the day when benefit payouts exceed contributions.
Bruce, payouts exceed contributions (excluding interest) in 2010. Additional debt held by the public was issued to pay this deficit, even though the interest could have paid the deficit.
Why is that? Because the interest was credited to the fund via debt through additional Treasury securitoes, rather than by cash. So, the interest had to be redeemed with cash, which resulted in additional debt held by the public, because the government had no excess cash due to its deficit.
How do ytou refinance a debt with more debt?
Well, if you’re the federal government, you can do that. When even the interest on the debt cannot be paid back in cash, the system is in a very deep hole.
Don Levit
rpl
Jun 30 2011 at 12:14pm
MattW has it exactly right. Everyone arguing things like “Social Security is not a Ponzi scheme because Ponzi schemes must fail” should go back and reread what he wrote. What makes a Ponzi scheme a Ponzi scheme is that it pays out on past contributions out of present contributions, all the while not generating any actual returns. If your plan does that, then it’s a Ponzi scheme, full stop. In practical terms, “Pay-as-you-go” and “Ponzi” mean the same thing.
A Ponzi scheme need not collapse. If you keep the promised returns low enough it can go on indefinitely. However, the returns that allow that to happen are a lot less than you could get by making an actual investment with an actual return, which is why Ponzi schemes generally rely on either fraud or official mandate, though neither is technically required. Virtually nobody who understands how such a thing works would participate in it willingly.
rhhardin
Jun 30 2011 at 1:10pm
As to returns to Social Security being low, you can’t do better privately.
The entire population can’t save at once. It’s a fallacy of composition.
If you replaced SS with 401k’s, the law would enforce itself via reduced returns on investment.
It would happen, for instance, as too many people selling stocks and not enough buying at once, unless the number of retirees and the number of saving workers reaches a balance, namely by deferring retirement; just as has to happen with the SS retirement age.
David R. Henderson
Jun 30 2011 at 1:30pm
@rpl,
What you said. I think you said it quite accurately and succinctly.
jeppen
Jun 30 2011 at 1:46pm
Swedish pensions is financed by all workers paying 18% of their income in a payroll tax, which is then distributed among retirees in proportion to how much they have contributed earlier (with a floor and a ceiling for payout). Very sustainable and clearly not a ponzi scheme.
Silas Barta
Jun 30 2011 at 5:57pm
@rhhardin:
The entire population can’t save at once. It’s a fallacy of composition.
Yes, yes they most certainly can, unless you use a non-standard, counterintuitive definition of “save”.
For example, imagine that everyone produces non-perishable goods. One year, everbody takes a positive fraction of their output, and stores it away, while consuming or trading the rest. Looks to me like everyone’s saving!
What you can do in that world-economy, you can do in our world-economy.
The people who think it’s impossible to save, typically have some definition in mind like, “saving means net purchasing government securities”, and then look at the private sector as a whole, noting that for them to save *in that respect*, the government must dissave.
But who cares about that case? Under the important meanings of “save”, everyone can do it. At the same time. Over the whole world. Or universe.
rhhardin
Jul 1 2011 at 5:58pm
@Silas Barta
Good point, let me see if I can work it out.
The original idea is that future goods and services will be supplied by future workers, and saving today will be saving dollars, which are tickets in line to say what the economy does next, presumably something for you.
When retirement comes, you use your tickets, which come out of the future money supply by being uninvested (sell your stocks) whence they are handed to you; somebody else gives up his claim on the then current economy and gives it to you in exchange for your stocks.
Obviously if everybody cashes in at once in the future, either the value of the investments falls so as to ration the dollars extracted to the existing money supply, which is sized so that the economy neither goes idle nor has dollars bidding against each other into inflation; so everybody can’t save at once. The amount available to be unsaved in the future depends entirely on the capacity of the future economy.
Your idea is that instead of saving dollars, squirrel away nuts to be eaten or traded in retirement.
The problem is that the nuts come out of the current capacity of the current economy, unlike saving money which passes your claim on the current economy to somebody else.
It’s really quite a different kind of saving. In your scheme the future economy could be zero and you’d still have your nuts.
You could imagine planning that way in fact: let the future economy go to zero, we’ll just stash away today whatever we’ll need in the future.
Nobody will work in the future.
Is there a natural limit to that? In which case it runs into the saving idea.
John Seater
Jul 2 2011 at 5:35pm
The woodworking class finally is over. Back to the salt mines.
To rpl,
Well, if you want to redefine the term Ponzi scheme in that way, calling Social Security and Medicare Ponzi schemes carries no useful information. The term Ponzi scheme has negative connotations precisely because the traditional meaning of a Ponzi scheme was an unsustainable fraud. Peter Diamond showed conclusively decades ago that programs like Social Security can be solvent forever and *can improve social welfare.* Nothing unsustainable or fraudulent about that. Social Security, and also Medicare, are not Ponzi schemes.
I prefer not to redefine words for political convenience. Those who oppose Social Security and Medicare are going to have to work harder at coming up with arguments against them than just yelling “Ponzi scheme.”
Nicholas Shackel
Jul 3 2011 at 3:57pm
No, you’re all wrong: the difference between social security and ponzi schemes is that the government forces you to give money to social security but ponzi schemes are voluntary, so that’s why ponzi schemes are wrong. Anyway, see this discussing similarities to Enron and Madoff, http://blog.practicalethics.ox.ac.uk/2011/01/politicians-and-penzions/,
or if you prefer, you can see the colonel and pocahontas discuss it here:
http://www.xtranormal.com/watch/11235251/politicians-and-penzions?listtype=ALL
JD
Jul 24 2011 at 10:08pm
Isn’t it structured like insurance?
People pay their premiums not knowing if they will get commiserate benefits or ever need any payout whatsoever. Current premiums go into an account paying current claims – not reserved specifically for future payouts to the original payer.
Comments are closed.