Is Social Security a Ponzi Scheme?
Ever since Rick Perry derided Social Security as a Ponzi scheme, economists and other pundits have jumped into the fray. Progressive blogger Matt Yglesias says it’s “nuts” for anyone to talk like this, because Social Security merely relies on future economic growth — just like a private pension plan. Free-market economist Alex Tabarrok responded to Yglesias with links to arch-Keynesians (and Nobel laureates) Paul Samuelson and Paul Krugman, both comparing Social Security to a “Ponzi game.”
In the present article I have three aims: First, I will point out that the critics are right; to the extent that Social Security “worked,” it was because of its resemblance to a classic Ponzi scheme. Second, I will show how private-sector retirement planning operates nothing like this. Third, I will defend the good name of Charles Ponzi from the scurrilous comparisons — what he did was nothing like the racket known as Social Security.
Social Security’s “Ponzi Game Aspects”
Paul Krugman is a famous guy with a long record of strong opinions. It’s to be expected that periodically these will come back to bite him. His usual tack is to deny that his old columns meant what their plain-word reading would indicate. For example, Krugman can’t believe anybody thought this column (from 2002) should be construed as his endorsement of Greenspan trying to create a housing bubble.
When it comes to Social Security, here’s what Krugman wrote in late 1996:
Social Security is structured from the point of view of the recipients as if it were an ordinary retirement plan: what you get out depends on what you put in. So it does not look like a redistributionist scheme. In practice it has turned out to be strongly redistributionist, but only because of its Ponzi game aspect, in which each generation takes more out than it put in. Well, the Ponzi game will soon be over, thanks to changing demographics, so that the typical recipient henceforth will get only about as much as he or she put in (and today’s young may well get less than they put in).
As with his unfortunate housing-bubble article, here too Krugman has had to do damage control. After the above column floated around the Internet, Krugman tried to quell the giggling, claiming that anyone who tried to use him in support of Republican claims was playing “word games.” Krugman then gave a link to this fascinating history of the original Ponzi scheme, courtesy of — the Social Security Administration! (It seems they must get this a lot.)
I was curious to see how the Social Security Administration would defend itself from the charge that it was a Ponzi scheme. Here’s what they say:
In contrast to a Ponzi scheme, dependent upon an unsustainable progression, a common financial arrangement is the so-called “pay- as-you-go” system. Some private pension systems, as well as Social Security, have used this design. A pay-as-you-go system can be visualized as a pipeline, with money from current contributors coming in the front end and money to current beneficiaries paid out the back end...
There is a superficial analogy between pyramid or Ponzi schemes and pay-as-you-go programs in that in both money from later participants goes to pay the benefits of earlier participants. But that is where the similarity ends...
As long as the amount of money coming in the front end of the pipe maintains a rough balance with the money paid out, the system can continue forever. There is no unsustainable progression driving the mechanism of a pay-as-you-go pension system and so it is not a pyramid or Ponzi scheme.
Contrary to the claims of Yglesias, Krugman, and the Social Security Administration, I don’t think the “Ponzi scheme” charge is unfair in the slightest. When critics say Social Security is “unsustainable,” they quite obviously mean that it can’t keep up the current taxing and benefit schedules. Either taxes on workers will go up, promised benefits will be reduced, or some combination of the two. Krugman’s 1996 column confirms that analysis, and the Social Security Administration’s pipeline does too.
Up until now, retirees have been taking out more than they put in, and that can’t continue — this pattern relied on finding ever more workers to join the system. In other words, it was a classic Ponzi scheme. I am not here to endorse candidate Rick Perry, but the point of his charge is obviously true: each generation can’t keep taking more out of the system than it put in, once the demographics change.
The SSA’s pipeline graphic is interesting. If that is ultimately what Social Security turns into, and if each generation of workers merely takes out “what it originally put in,” then it means workers will earn a zero-percent (real) return on their “contributions” into the system.
Yes, that would certainly be “sustainable” in an accounting sense (at least with a stable age distribution in the population), but would it work politically? If politicians frankly told voters, “When we take $1,000 from you at age 25, don’t worry, that $1,000 will be waiting for you when you’re 65,” would they be happy with this arrangement? Charles Ponzi too could have made his scheme more sustainable if he promised his investors a 0 percent rate of return, but then nobody would have been interested.
In fairness, Matt Yglesias points out that the pipeline method can yield a positive rate of return. If the workers at the left end of the pipe always pump in, say, 15 percent of their paycheck, then (if productivity grows over time as it normally does) 50 years later, when they are on the other end of the pipe, there will be more dollars shooting out. However, in this scenario we’re back to an arrangement where each generation gets out more than it put in — what Krugman himself thought was a “Ponzi game aspect.” In any event, Yglesias’s framework is still vulnerable to demographic shifts.
Why Private-Sector Retirement Planning Works
The confusion in popular discussions of Social Security partly rests on the general ignorance of how an entire community can actually become richer through saving and investment. In other words, a lot of people believe (whether or not they’ve really thought it through carefully) that for every Sally out there who’s saving $10,000 per year, there must be some Jim who’s racking up $10,000 in debt. Therefore, whenever Sally starts living off her savings, people imagine that Jim must be cutting back on his own standard of living. At the communal level — so the thinking goes — everything is a wash, and we’re just changing the distribution of “total output” based on which people were frugal and which were spendthrifts.
This mindset is totally wrong. I explain things methodically in chapter 10 of my introductory textbook, but here’s the gist: It’s possible for everyone in the entire community to “live below his means,” that is, to consume less than his income and to save. The economy is then physically capable of reducing the output of consumption goods (TVs, sports cars, steak dinners, etc.) and increasing the output of investment or capital goods (drill presses, fertilizer, MRI machines, etc.). In the future, the larger quantities of various tools and equipment make the workers more productive than they otherwise would have been. That’s why the standard of living can rise; the community is physically capable of cranking out more goods and services because of the past investments.
Think of it like this: During his working career, a farmer takes some of his crop every year and uses it to buy a component for a tractor. One year he buys a tire, another year he buys a steering wheel, and so on. After working for 45 years, the farmer is ready to retire. By this point, he has assembled a brand-new tractor. Now he no longer needs to use his labor to earn an income. Instead, he rents out use of the tractor to the younger workers (who otherwise would have to use their bare hands to till the soil, etc.).
From a certain viewpoint, the retired farmer would be “skimming off the top” every time he ate an ear of corn harvested after he no longer worked the fields himself. After all, that corn would be part of that year’s harvest, so if the retired farmer ate it, there would be less corn available to the people who actually picked it. Yet the retired man’s consumption wouldn’t be financed through a “contribution” or “redistribution” from the young workers that year.
On the contrary, those young workers would be earning their full market wage (and if they were smart, they’d be saving some of it for their own retirement). The retired farmer would buy the corn on the open market, with the income he earned from renting out his tractor. There would be more corn to go around because he had spent decades assembling the tractor, and others in his cohort had built up stockpiles of fertilizer, hoes, irrigation equipment, etc.
Obviously my tale isn’t realistic, but it serves to get across the essence of voluntary retirement planning. People can get out more than they put in (measured in physical terms) because of what Böhm- Bawerk called the superior physical productivity of roundabout processes. As I complained during the debates over George W. Bush’s “privatization” proposals, many supposedly pro-market reformers want to get the magic of compound interest without the discipline of saving for decades.
A (Very Qualified) Defense of Charles Ponzi
Above I’ve explained why the “Ponzi scheme” accusation is accurate, in the context of modern political debates. However, there is a very important sense in which it is unfair — unfair to Charles Ponzi.
It’s true that Ponzi engaged in fraud; his victims never would have “invested” with him, had he accurately explained the business model. Libertarians therefore agree with everybody else that Charles Ponzi was a criminal and would have to face legal consequences in any just legal order.
However, so far as we know Ponzi never threatened anybody. He didn’t tell struggling young workers, “Give me 15 percent of your paycheck every week, so that I can make you a fantastic return — or else I’ll send goons to kidnap you.”
In this respect, Social Security isn’t a Ponzi scheme after all. It’s more analogous to mobsters shaking down people for protection money, because otherwise “bad things could happen.”
The complaints about Social Security are accurate: The only reason it has enjoyed such “success” thus far is that it relied on increasing contributions from each new generation of workers. Now that the demographics have turned against the system, it is literally unsustainable. We will see increased taxes on workers, reduced payments to beneficiaries, or some combination of the two.
In the voluntary private sector, people can plan for their own retirement through genuine saving and investment. They don’t need to extract concessions from the next generation of workers, because the retirees’ prior savings allow the creation of capital goods that will provide income when their bodies no longer can do so.
Finally, in one important respect a classic Ponzi scheme is less dangerous than Social Security: It relies on fooling people into voluntarily handing over their money. Once the fraud is detected, the danger is eliminated. In contrast, American workers have no choice but to “contribute” to Social Security, whether they like the deal or not.
for The Daily Reckoning
Ed. Note: Robert Murphy is an adjunct scholar of the Mises Institute, where he will be teaching “Anatomy of the Fed” at the Mises Academy this winter. He is the author of The Politically Incorrect Guide to Capitalism, the Study Guide to Man, Economy, and State with Power and Market, the Human Action Study Guide, and The Politically Incorrect Guide to the Great Depression and the New Deal.
When Economic Growth is a Thing of the Past
Reckoning from Buenos Aires, Argentina...
We think we’re onto a big story. A BIG story.
This correction is aiming high...it’s going to take down the entire capital structure of the world’s developed economies.
Stocks...bonds...real estate — watch out...they’re all going down.
The dollar...the pound...the euro — look out below!
But that’s not all. No, if we’re right, this is bigger, much bigger than just a market correction.
It’s an economic correction...a monetary correction...and a political correction.
But we’ll come back to that in a moment. First, let’s look at what happened yesterday. The Dow lost 108 points. Not much information content there...
..but look at what happened to gold. It was down $35. Could gold be finally testing its admirers? Though still in a major bull market, could it be correcting...possibly falling back to the $1,000-$1,500 range?
Yes it could. Gold’s time will come. But we don’t think it is here yet. Gold has risen in anticipation of trouble. But the trouble gold buyers foresaw hasn’t come...not yet. There’s been massive money- printing. Still, in terms of the goods and services it will buy, gold has held up pretty well.
Gold will take off — when the anticipated trouble becomes real here- and-now trouble. And that probably won’t happen for a while. And part of the reason it won’t happen is this Big Story we’re following.
You see, our whole economy...and our society...and our government...and much of what we think...all were built on truths that are no longer true.
In a word or two, our modern economy — and our government — depends on growth. And growth may be a thing of the past.
You want to make money, you invest in profit-making businesses, right? Not necessarily. On the whole, investments in stocks only go up if the economy grows. Otherwise, companies are just fighting for market share. One goes up, but another goes down. Taken all together, investors go nowhere.
Well, at least you can always put your money in bonds. You won’t earn a lot of money, but over time you’ll receive safe, sure gains. Right?
Wrong again. Practically all the world’s major debts — private, corporate and government — depend on growth. Without growth, the debtors can’t pay. And if they can’t pay the debt is worthless.
Do you hold Japanese Government Bonds, dear reader? Good luck with that!
But those points are obvious, aren’t they? How about this: if you want healthier people, you just grow your health-care institutions, right?
Wrong again. In terms of a percentage of GDP, Chile spends only a third as much on health care as the US — much less in absolute dollars. Life expectancy in the US is 77.6 years. How long do you think they live in Chile? Well, we’ll tell you — 78.6 years.
Maybe there’s something in the water in Chile. But suppose you could take a group of Americans and give them all the free health care they want. Would they live longer?
Well, guess what, the Rand Corporation tried it. And guess what it found? Except for people who were extremely poor and had no access to health care previously, giving normal people more health care did not make them healthier. The group with free health care consumed a lot more resources from the health industry — about 25-30% more. But it was no healthier.
And guess what else? When it comes to surgery, who do you think comes out ahead — people on Medicaid...or people with no health insurance? The people with no health insurance, of course.
These facts and figures come from a delightfully moronic book called The Great Stagnation, by Tyler Cowen.
He points out that the results from educational spending are similar. In 1971, the US spent a little more than $5,000 per student per year. Now, it spends more than $12,000. So guess how much reading scores have increased? Have they more than doubled too? Nope. They haven’t budged.
This is especially interesting because of something known as the “Flynn Effect.” Flynn noticed that kids were getting smarter every year. So, if IQs are going up, you’d naturally expect test scores to go up to. But they’re not. Which suggests that the quality of educational inputs is going down...so that the results end up in the same place.
In other words, the great Truth of the Modern Age — that further inputs produced further outputs — is no longer true.
And more thoughts...
What’s the connection between education and government debt? Why are we trying to compare stock market gains with gains in health care?
Here’s where The Great Stagnation falls apart. Its author completely misses the point. He thinks the “low hanging fruit” has already been picked. In a way, he’s right. The big gains in output — in education, health care, heavy industry, farming, banking, debt and many other areas — have already been made. Now, it’s hard to make any successful investment in any area...
..if you invest in more health care...it will probably be a waste of money.
..if you spend more on education (not individually, but collectively), that too will probably be money down a rathole...
..if you increase the level of credit (as the government is trying to do)...you might as well save your money.
..no point in investing in the stock market either. The glory days are over...
..and stay away from the bond market. The debtors won’t be able to pay...
Yes, we’ve entered an era of ‘Great Stagnation.’ And yes, it looks as though the low hanging fruit has been picked.
Tyler Cowen thinks this is a problem that we can fix. He thinks we just have to put our thinking caps on.
The silly goose. He doesn’t realize that the era of low-hanging fruit changed the way we look at things too. It made our arms shorter and our brains smaller. We are all dumb optimists now. That’s what 300 years of finding low-hanging fruit does to a people. We think that every downturn — even a Great Stagnation — can be reversed by, among other things, raising “the social status of scientists.”
No kidding. That’s what he recommends. As if the social status of people was determined by an act of intellectual will.
What a disappointment. We began reading The Great Stagnation thinking its author was a closet Dear Reader. Instead, he turns out to be a disciple of Thomas Friedman.
More on the real causes of the Great Stagnation...tomorrow...
for The Daily Reckoning