One of the questions on Wonkblog’s Quora.com thread came from John Demarchi, who asked, “Is Social Security a ‘Ponzi Scheme’? If it isn’t, why isn’t it? If it is, how do we fix it?” I’ve been meaning to address this talking point for some time, so thanks, John, for giving me the opportunity.
In the 1920s, Charles Ponzi thought he had figured out a way to game an inconsistency between the Italian and American postal systems. He hadn’t. But rather than return his investor’s money, he told them his scheme was working, and used his salesmanship to recruit other investors. He used that money to pay back his first investors, and then flaunted his success -- and the testimonials of his happy investors -- to rope in more suckers. He used their money to pay back the second set of investors, and so on. Eventually, he couldn’t find enough new investors to pay back the swollen ranks of old investors and the scheme fell apart.
In other words: A Ponzi scheme is generally a system in which investors think they’re investing in something real but are instead being used to pay one another back. Eventually, the scheme runs out of new investors and collapses.
Here’s how the Social Security Administration -- which, somewhat touchingly, has a whole web page explaining why its not a Ponzi scheme -- describes Social Security: “It would be most accurate to describe Social Security as a transfer payment--transferring income from the generation of workers to the generation of retirees--with the promise that when current workers retire, there will be another generation of workers behind them who will be the source of their Social Security retirement payments.”
The superficial similarity to a Ponzi scheme is that different sets of investors are relying on future investors, or at least future growth, to get paid back. But that defines a Ponzi scheme so broadly as to make the term meaningless. In that definition, any intergenerational transfer system is a Ponzi scheme.
What makes a Ponzi scheme a Ponzi scheme is that it’s a giant fraud. People think they’re investing in postal stamps. Their money is actually being invested in nothing. In Social Security, conversely, it’s perfectly clear what is going on. Every year, Social Security’s actuaries release an insanely detailed report on the system’s finances, its balance of payments, the potential problems it could face, and so on. You can read their report here. In a Ponzi scheme, the finances are a secret, and that’s central to the enterprise. In Social Security, they are, as a matter of law, public.
Indeed, Social Security has a much more obvious financing structure than, well, almost anything else in the government. Consider how the Pentagon gets funded. It has no dedicated funding of its own. No one knows exactly how it will be paid for, or at what level, 20 years from now. Instead, every year, there’s a budget. Every year -- at least recently -- that budget calls for more spending than the government is taking in in taxes. So we just borrow the extra money.
Social Security, by contrast, has its own dedicated funding source. It is currently running surpluses, though it won’t be doing so for very much longer. Those surpluses are invested in U.S. Treasuries, which are widely considered the world’s safest investment. As I’ll explain in a moment, it needs adjustments to remain actuarially sound in the future. But compared to almost everything else in the federal government, its path to financial stability is clear.
The other characteristic of Ponzi schemes is that they tend to require huge increases in the number of participants in order to stay afloat. As the Social Security Administration explains, “to pay a 100% profit to the first 1,000 investors you need the money from 1,000 new investors. Now there are 2000 ‘investors’ in the scheme, and in the second round of payouts to pay the same return to these 2,000 investors in the next round, you need the money from 2,000 new investors--bringing the number of participants to 4,000. And to pay these 4,000, you will end up with 8,000 ‘investors,’ then 16,000--and so on.” This type of geometric explosion looks like a pyramid, which is why Ponzi schemes are often called “pyramid schemes.”
Social Security doesn’t look like a pyramid. Quite the opposite, actually. Its current funding shortfall is a product of the baby boomers retiring and birth rates declining. That means more beneficiaries and fewer workers than there were when, say, the boomers were working and their parents were retiring. So Social Security has a funding gap equal to 0.7 percent of GDP over the next 75 years. We could wipe that gap out by lifting the payroll tax cap (right now, payroll taxes only apply to the first $107,000 of income) or by adjusting benefits downwards. Once it’s done, however, it’s done. Stable. Again, quite unlike a Ponzi scheme.
That essential stability is, perhaps, the most obvious refutation of the Ponzi scheme argument. The Social Security Administration puts it well on its Web site. “The first modern social insurance program began in Germany in 1889 and has been in continuous operation for more than 100 years. The American Social Security system has been in continuous successful operation since 1935. Charles Ponzi’s scheme lasted barely 200 days.”