As we head toward the 2012 election, you’ll probably hear more politicians echo the thoughts of Texas governor Rick Perry and call Social Security a Ponzi scheme. The mouth of a politician isn’t always the best source of accurate information. Is Rick Perry’s assessment correct?
Before determining whether or not Social Security is a Ponzi scheme, we need to cover a little Ponzi scheme history and understand how it works.
Who was Ponzi, and what was his scheme?
Charles Ponzi was a career criminal who stumbled upon his bright idea in 1919. In theory, he was investing in international reply coupons. International reply coupons were redeemable for first class international postage in any country that was a member of the universal postage union. The international reply coupons bore different prices in different countries, due to differences in the underlying international postage rates.
Ponzi claimed to be making a profit by buying coupons in a country where the cost was low and selling them where the cost was higher. In theory, it was definitely possible to generate a small (and legal) profit via arbitrage.
If you’re having trouble with the concept of international reply coupons, let’s use an analogy. Imagine that Al’s car wash and Bob’s car wash use identical tokens. Al sells the tokens for $3 and Bob sells them for $4. You could make a profit by buying Al’s entire supply of tokens and selling them to Bob’s customers for $3.50. Now, imagine that Al is Spain, Bob is Argentina, and the tokens can be used for international postage.
Ponzi claimed to need outside funds to get the ball rolling, and promised a 50% return on investment in 45 days – or 100% in 90 days. (Skeptic question: if it was so easy to make a profit with international reply coupons, why didn’t Ponzi have competitors?)
What Ponzi was really doing, of course, was simply taking money from each new round of investors and using it to pay off the previous investors. Most of the early investors didn’t even want their money back – they preferred to let it ride and continue to rack up huge amounts of paper profits.
Finally, Clarence Barron (yes, the guy the magazine is named for) analyzed Ponzi’s financials. For Ponzi’s story to be true, the number of international reply coupons making their way through the Ponzi organization would need to exceed the actual number in circulation – by a factor of several thousand.
Down came Ponzi’s scheme, a short nine months after it started. In the nearly 100 years since Ponzi’s scheme, others have tweaked his initial design and run successful versions of their own.
You’ll often hear that a Ponzi scheme will quickly collapse, because the number of investors needed to perpetuate the scheme will quickly exceed the number of people on earth. This is not exactly true. The new investments don’t necessarily need to come from new investors – they could be from current investors doubling down on their “investments”. The life span can also be extended if the operator isn’t actually paying the investors, but is simply crediting their account for the earnings. Set the interest rate high enough and nobody will want to pull their money out.
In part two, we give an example how Social Security works. Finally, in part 3 we put the two pieces together to answer the question and determine whether Rick Perry was right or not.