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.
The Biz of Life says
Good try, but the only reason Social Security isn’t a Ponzi Scheme is because the government says it isn’t a Ponzi Scheme and can back up the program with the printing press if it had to. Economists as diverse as Paul Krugman (http://www.bostonreview.net/BR21.6/krugmann.html), Paul Samuelson (http://blog.scrivener.net/2005/02/beauty-of-social-security-by-paul.html), Milton Friedman (http://www.hoover.org/publications/hoover-digest/article/7523) and Don Bourdreaux (http://cafehayek.com/2011/09/further-thoughts-on-whether-or-not-social-security-is-ponzi-scheme.html) have called it such. The big advantage the government has, unlike Ponzi, is that it can use the law to compel everyone who earns a salary to participate. It is a pay-as-you-go system where everyone’s funds are commingled and the promises to early investors are paid off with late investors money. This has been a great program for our grandparents and parents, who received much more in benefits than they paid in, but as demographics change (i.e. late investors become fewer and fewer) it will not be a particularly good deal for us, and will be an absolutely lousy deal for our kids and grandkids. So you can call Perry a wingnut if you want, and say he is scaring seniors, but he is one of the few people in politics calling the program exactly what it is. If you want to use more pleasant terms, we can say it is actuarially unsound. Is the Chile model of placing Social Security into private accounts so there are no political shenanigans with the money and it is truly in a lockbox? Only time will tell if we have the political will to reform this deeply flawed program.
Lazy Man says
The Biz of Life,
I think you need to get to part 2 and 3 before making a point on whether Social Security is a Ponzi Scheme. You are jumping the gun a bit :-).
I haven’t called Perry anything. I’ll be the first to admit that I’m not into politics and I don’t follow what all these say. I just happened to catch the snippet of him clearly saying that Social Security is a Ponzi scheme and think it deserves a lot more investigation.
The Biz of Life says
Perhaps I did jump the gun a bit, but I’ll stick with the Nobel Laureates (Krugman, Samuelson and Friedman) who opined years ago that Social Security is a government sponsored Ponzi Scheme.
Lazy Man says
What may have seemed true years ago is not necessarily true today and may not necessarily be true of tomorrow.
Well let’s see. I’ve been paying into this so- called retirement vehicle for over 40 years, with no choice in the matter, with the high hopes of some day claiming it back. What? It went to my grandparents? What? It went to my parents? What? The govt. spent it? If not Ponzi scheme, certainly theft. Unless I am fortunate in getting 40 years worth of my money back….
It’s not far off from the truth, although associating social security with a Ponzi scheme is a little off colour. When social security was implemented it was designed for the good of humanity, not as a scam to steal money from people. I can understand how Perry can illustrate it to prove his point, but it lacks any true validity.
I anxiously await to prove the validity of Social Security when it provides for the good of my humanity.
Jon B Pennington says
Social security is most emphatically NOT a Ponzi scheme! In a Ponzi scheme the suckers had a choice.
It may be that Social Security isn’t a Ponze scheme, but it fails to meet our expectation of what we think it SHOULD be. It’s not and never was a retirement plan, but a supplement to lost wages due to old age. That’s more like welfare than retirement, but it won’t provide a comfortable retirement if that’s close to all that you have.
Any doubt about Social Security should be converted into an action plan to increase retirement savings.
Lazy Man says
@Kevin, do you think “our” (American’s) expectations were justified to think that? I’m 35 and I personally never had that expectation. Perhaps the generation before me did.
@StLPastor, I don’t think there’s a Ponzi Scheme definition that allows for an indefinitely sustainable system.
Wow, emotions are an amazing thing-you’ve got us stirred up on this one!
Anyway, I am curious about the history of Ponzi, crazy that you can convince people they can make 50% returns. I expect you’ll do an equally thorough job on the basics of Social Security. (reading through a couple of Biz’s links, I’d say it will depend on how we define Ponzi: it’s Ponzi-like since each generation pays off the generation before, but not Ponzi-like, in that it’s sustainable indefinitely with minor correction.
A little off topic since I am waiting for Part 2 and part 3 but I would love the opportunity to opt out. I keep my 6.2% my employer keeps his 6.2% and I never claim a dime from the system!
I don’t think that social security is a Ponze Scheme. If you look to the origins of social security it was originally implemented in Germany. When you reached age 65, then you started receiving payments. However, rarely did someone live to age 65 when it was started.
On that note, I think it is just another mismangement of the federal government. Just like the post office, medicare, and spending.