Is Social Security a Ponzi Scheme?

Posted by Jeffrey Brown on Sep 25, 2011

Filed Under (Retirement Policy, U.S. Fiscal Policy)

A hot topic in the recent Republican presidential candidate debates has been whether it is fair to characterize Social Security as “Ponzi scheme,” as Governor Rick Perry has done.  For this assertion, he has come under criticism from, among others, former Massachusetts Governor Mitt Romney.  Political rhetoric aside, this raises an interesting question.  Is Social Security a Ponzi scheme?

 Many individuals may be hoping for a simple “yes” or “no” answer to this question.  But like so many policy questions, the answer is a somewhat less satisfying “sort of.” 

 To explain, we need to start with a definition of a Ponzi scheme.  According to the U.S. Securities and Exchange Commission, a Ponzi scheme is:

 “an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.”

 The name of this scheme comes from the exploits of Charles Ponzi, who back in the 1920s promised his “investors” an enormous rate of return (according to the SEC, 50% in just 90 days, relative to the 5% people could get in a bank account) by investing in postage stamp speculation.  The modern-day equivalent is Bernie Madoff, who more recently defrauded individuals, non-profits and institutional investors out of enormous sums of money (on the order of $50 billion according to Forbes) in order to support his lavish lifestyle. 

 So let’s compare Social Security to the likes of Ponzi and Madoff. 

 How does Social Security look like a Ponzi scheme?

 The characteristic of Social Security that most closely parallels the misdeeds of Ponzi and Madoff (and gives rise to the claim that Social Security is one giant Ponzi scheme) is that Social Security pays one generation using the contributions of the next.  Just as Ponzi and Madoff used the money from new investors to pay off prior investors, rather than actually investing the funds in real assets, so too does Social Security take contributions from current workers and use it to pay off current retirees.  Like the Ponzi schemes, Social Security is not investing the money in productive real assets.  We economists refer to this design as a “pay-as-you-go” system (as opposed to a funded system where the money would be invested to pay off future benefits).  But it sounds an awful lot like the part of the SEC definition above that states “payment of purported returns to existing investors from funds contributed by new investors.” 

 How does Social Security NOT look like a Ponzi scheme? 

 The first difference between Social Security and the likes of Ponzi and Madoff is that the Social Security system is legally enforceable.  Ponzi schemes do not “blow up” until the purveyor of the fraud runs out of new money at a time when some of the old money wants out.  With Social Security, the government has the ability to force contributions by levying taxes on current and future generations or by borrowing money (which is just another way of levying taxes on future generations).  Nobel prize winning economist Paul Samuelson showed the world many decades ago that pay-as-you-go systems can go on forever, offering a rate of return equal to the rate of population growth plus productivity growth, so long as demographics are stable.  The problem facing Social Security is that people are living longer, working less, and having fewer children.  So as the ratio of workers-to-retirees falls, it becomes more and more expensive for today’s workers to pay for today’s retirees.  So the system may be fiscally unsustainable (i.e., we may not like the tax rates required to keep the program going), but the government does have the ability to keep it going if it is willing to impose such high taxes.

 A second difference is that Social Security does not purport to offer “high returns” as did Madoff or Ponzi.  It is true that it offered higher than market returns to the early generations, who received back far more than they contributed, but nobody today serious argues that the rate of return on Social Security is greater than that which can be achieved in the market.

 A third difference is that nobody in the government is skimming money off the top or personally profiting from the money.  I suppose one could argue that the U.S. Congress and every President since Ronald Reagan have all conspired to “skim the money” by using Social Security surpluses to mask the magnitude of the deficits we were running in the rest of government.  And in that way, these politicians may have “profited” in a political sense, as it allowed them to provide higher services to the public while not paying the full price.  This is a fair point.  But it is also the case that the very same people who are “investors” in the program (e.g., taxpayers) are largely the same individuals who benefit from whatever largesse the government doles out. 

 Summary        

 I understand the temptation to call Social Security a Ponzi scheme, particularly when a politician is looking for an easy way to explain a fairly complex program (I certainly don’t consider it a “crime,” as does the Huffington Post).  But it is certainly not the most accurate description of the program.  Most of all, the problem with calling it a Ponzi scheme is that name-calling does not really help us understand how to solve the problem.  In a real Ponzi scheme, we bring in the Feds, we shut down the fraudster, and we let the courts sort out who loses.  With Social Security, we need our leaders in both parties to provide meaningful ideas on how they will bring Social Security’s finances back onto a sustainable path.  If calling the program a Ponzi scheme somehow helps us to get a solution, then so be it.  But I suspect it will do little more than stir the political juices on both sides of the aisle, allowing both Democrats and Republicans to demagogue the issue, rather than suggesting meaningful solutions.

 

One Response to “Is Social Security a Ponzi Scheme?”

  • Marcus Casey says:

    This post should be posted on the New York Times and other websites. Perhaps it will end this as a talking point. In discussing the SS as Ponzi scheme issue with people (non-economists) over the last couple weeks, I realize that much of the shock and dismay stems from no understanding popular discussions about SS trust funds and lockboxes I shocked a couple group of older women(my grandma included) by explaining to them the pay as you go aspect and why tax increases were relevant for the discussion. They were under the impression their benefits were being paid from some account. I think the lac of civic education about basic government programs makes these sorts of issues more volatile than they need be.