Social Security is a Paygo scheme. Paygo schemes are not Ponzi schemes. Yes, both need to sustain themselves with an influx of new money, but that is not a flaw in and of itself.
As each new generation of Americans is born and the oldest dies off, Social Security gains new “investors” and drops old ones. As long as the ratio of people giving to SS and people taking from SS stays in certain limits, it can go on forever. The entire Baby Boomer issue is a demographic problem, not a structural one. Think of it this way:
Divide the population into nine age clusters 0, 10, 20, 30, 40, 50, 60, 70, 80. The 0 cluster is for people between the ages of 0-10, the 10 cluster is for people 10-20, the 20 cluster is for people 20-30, etc. For the sake of argument, we will assume each cluster has the same number of people, the 0 and 10 clusters neither gives nor take from SS, and that no one lives past 90. We can make a fuss about the actual numbers but it’s not necessary for this example. The people in clusters 20-60 each give $10 dollars to SS. SS now has $50. SS then distributes $25 to clusters 70 and 80. SS now has nothing, clusters 20-60 are down $10 each and clusters 70 and 80 have $25 each.
Advance the situation ten years. Everyone advances a cluster, and everyone in the 80 cluster die of. The 0 cluster gets filled up with babies from the earlier clusters. The people in clusters 20-60 each give $10 dollars to SS. SS now has $50. SS then distributes $25 to clusters 70 and 80. SS now has nothing, clusters 20-60 are down $10 each and clusters 70 and 80 have $25 each.
Now, if we go though this through a couple of cycles, we can see that while the “payoff” is break-even for the investors after the first 20 cluster becomes a 70 cluster, there is no real reason why this can’t go on forever. A stable Paygo system can be built. We can adjust the numbers to increase or decrease payouts, but that is not needed for this exercise. The baby boomer bulge and increasing life expectancy are issues that may cause us to adjust payouts and taxes, but these are demographic problems, not problems with a Paygo system itself.
Ponzi schemes are different animals altogether. While they need new investors to pay off the old investors, but that is not what causes them to collapse. What causes the Ponzi scheme to collapse in the end is that the person running the scheme has to pretend he is sitting on an ever increasing pile of imaginary money.
Our previous example isn’t very good for showing how the Ponzi scheme works and why it fails, so we will use something a little different. Investor 1 shows up and deposits $100 dollars with the “bank” at a 50% rate of return. After a year passes, he shows up at the door and says he would like his dividend of $50 and to leave $100 in the bank. The bank gives him $50, but takes it out of his original $100. The bank has $50, but investor 1 thinks the bank has $100. The bank has created $50 of imaginary money. Investor 2 shows up at the same time and says it looks like a good deal, so he deposits $100 that same day. The bank now has a total of $150 of “real” money and $50 of imaginary money.
Investors 1 and 2 show up a year later and each take out another $50 in dividends, for a total of $100. They decide to leave their original investments intact and walk away thinking that there is $200 in the bank, when there is really only $50 in cash and $150 in imaginary money.
As we can see, each time the “bank” makes a payout it creates more imaginary money. But the interesting thing is that unlike a Paygo system, the Ponzi scheme can keep going even without new investors.
The investors show up again. They think they have $200 in the bank and $100 in dividends coming to them, but the bank only has $50 in cash and $150 of imaginary money. The bank manager convinces them to “reinvest” their earnings rather than accept a payout (cause there is no way he can pay both of them). They think this is a wonderful idea and tell the manager to make the arrangements. The investors leave thinking they have $300 in the bank, when there is only $50 cash and $250 in imaginary money. This is how Bernie Madoff managed to create almost $50 billion dollars of non-existent money.
The scheme can be run for a long time either by bringing in new investors or by convincing old investors to “reinvest”, but each time the bank does either, the amount of imaginary money goes up, and there is no way to get rid of it. This imaginary money is what eventually brings the scheme crashing down, because sooner or later, someone will either ask a question about the imaginary money that the bank manager can’t answer, or want to withdraw more money than actually exists.
The scheme run by Charles Ponzi actually had people investing until the very end despite other people’s suspicious, but it was brought down by a single newspaper article that crunched the numbers and said Ponzi had to have made more money in Postal Reply Coupons than actually existed when you added up all the Postal Reply Coupons in circulation. Ponzi couldn’t maintain the illusion of millions of dollars of imaginary money, and it all fell apart.
The Paygo system doesn’t use imaginary money at all. They tell you outright, “we are taking your money and giving it to someone else”. You might not like that, but that doesn’t make the Paygo system a Ponzi scheme.
