Kozlowski: Mechanisms driving Social Security and Ponzi schemes the same

Rick Perry has a way of getting liberals either to smirk or to scream.

One of his latest… Rick Perry has a way of getting liberals either to smirk or to scream.

One of his latest claims — that Social Security is a Ponzi scheme — engendered both reactions. Perhaps it wasn’t the most politically astute thing to say, as it adds up to almost perfect ammunition for Jon Stewart. Yet amid all the mirth and irritation following the Texan’s remark, a question remains:

Was his statement unfair?

No, it wasn’t.

A Ponzi scheme begins when someone  pretends to start a mutual fund — that is, a system in which a bunch of people contribute money to a pool to buy a set of stocks and other securities. Real mutual funds have the advantage of providing a lot of money that can be invested by the fund managers in a diverse selection of securities. As a result of the investment diversity, participants can effectively buy a thousandth of a share in 1,000 companies instead of one share in one company. This diversification should earn a more predictable return, which is split between participants in the fund and the managers who bought and sold the actual stocks. Those who participate in the mutual fund can continue to watch their nest eggs grow on paper, or they can demand their money and cash out.

A Ponzi schemer takes advantage of the fact that a vast majority of people don’t know what’s going on with the money in a mutual fund at any one time, as well as the fact that as many people are depositing money in a mutual fund, fewer are pulling their money out. A schemer bets that as long as people keep depositing more money in the “fund,” he can pay those who are withdrawing from the scheme with that influx of deposits. The scammer can make money by siphoning off some of the cash that is flowing from people paying in and people cashing out. As long as more money is flowing into the scheme than flowing out — and the government doesn’t connect the dots — nobody will be the wiser.

Compare Social Security. Workers pay a tax on their incomes, matched by contributions from their employers. Money is collected into a pool, and the pool is used to pay out benefits. This is OK as long as more people are paying into the system than are claiming benefits. In the past, Social Security ran a large surplus, stacking up a $2.5 trillion dollar reserve to dip into. In March 2010 The New York Times said, “For accounting purposes, the system’s accumulated revenue is placed in Treasury securities.” The reserve is composed of money the government owes to itself. However, Social Security paid out more than it took in in 2010, so now the government has to pay itself the money it owes to itself. Does anyone see a problem?

To recap, Social Security is a system in which money is taken from people putting money into a fund, and paid out directly to people who withdraw money from the fund. The surplus is loaned to the government, which spends it and promises to pay itself back later. A Ponzi scheme is when investors put money into a fund, and those who want out are paid directly with the money put into the fund. Any surplus is spent by the person running the scheme. The basic mechanism of both concepts is the same, although the latter, of course, is illegal.

So why do some argue that Social Security is not a Ponzi scheme? In a discussion on the New York Times’ website, Paul Pierson of the University of California, Berkeley, argues that the government can raise taxes and jigger the benefit structure to sustain the program. For this reason, he posits, Social Security is sustainable whereas Ponzi schemes are not. However, when we reduce this argument to its essence, all it says is that Social Security cannot be a Ponzi scheme because it can use the law to remain in business. If Bernie Madoff had been able to force people to contribute to his scheme or revise the expected payoff he promised people, would he have be accused of running a retirement fund instead of a Ponzi scheme?

Robert Reich, a former labor secretary, tries another angle when he says that Social Security can call on the reserve fund of what it is owed by the government to stay solvent, hence, in Reich’s opinion, no Ponzi scheme. Problem: Let’s say Bernie Madoff had held $2.5 trillion in Treasuries — or even better, held $2.5 trillion worth of money he had promised to himself. Would that have made his scheme less of the Ponzi variety?

The most convincing argument that Social Security is not a Ponzi scheme is that Ponzi schemes are disingenuous whereas everybody knows how Social Security works. However, that Social Security is “common knowledge” is an assumption. You could also assume that everybody knows the basics of how the government works, but 38 percent of 1,000 randomly chosen Americans in a Newsweek poll wouldn’t pass the citizenship test administered to foreigners seeking naturalization. Social Security also operates on the lie that beneficiaries are simply paid back what they paid in, when this is not the case.

Two things should be surprising by this point. First, that The New York Times can publish a discussion as to whether Social Security is a Ponzi scheme and not carry an opinion from someone who says that it is, and second, that for all the poo-poohing of Perry’s comment, it is much harder to rebut than many would like to believe.

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