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 March 2005 The Beloved Ponzi Scheme
Obviously a scheme like this can't go on indefinitely. At some point, it won't be possible to draw in enough new investors to support the "returns" promised to old investors. At that point, the whole thing collapses on itself. That's why Ponzi or pyramid schemes like this are illegal. That is, of course, unless they're run by the federal government. In that case it's called "Social Security" and it's one of the most sacred and beloved entitlement programs ever devised. Unfortunately, the fact that this is the government's pyramid scheme doesn't mean it won't ultimately collapse. In fact, its potential repercussions are far greater than any similar scams run by penny-ante swindlers serving time in federal prisons. How Did this Happen?The Social Security program wasn't always like this. When it came into existence back in the New Deal era, it was only intended to be a retirement supplement. Somehow over time, many have come to expect it to completely provide for their retirement. In addition, it now pays survivor benefits above and beyond anything envisioned at its birth.The 80 million baby-boomers now nearing retirement have come to see it as a true entitlement. Unlike the first generation to draw Social Security checks, the baby-boomers spent their working years paying into the system. It's only natural they feel entitled to eventually reap the benefits. This wouldn't pose a problem if their payroll taxes had actually been invested at even passbook rates. At least then something would be there waiting for them.
But this is a Ponzi scheme, remember? There never was any actual investment going on. It's just a transfer from today's workers to today's retirees. As the baby-boomers swell the recipient ranks, the entire scheme threatens to collapse under its own weight. And no, there really isn't a trust fund -- at least not as you would normally define it. Back in 2000 when presidential candidate Al Gore was blithering about putting it in a "lock box", the author of President Clinton's budget was writing that the trust funds "do not consist of real economic assets that can be drawn down in the future to fund benefits. Instead they are claims on the Treasury that when redeemed, will have to be financed by raising taxes, borrowing from the public, or reducing benefits or other expenditures." That last part is actually the solution of those politicians who have been ignoring the problem or for political reasons act as if it doesn't exist. Unlike Carlo Ponzi, the government can support its pyramid scheme through taxation. So far that's what's kept it going. But as the number of baby-boom retirees expands, the burden on current workers grows. As recently as 1950 there were 16 workers supporting each retiree. Currently that number has fallen to 3.3 and will drop to 2 by 2030. Most workers believe FICA -- that delightful Social Security payroll tax coming off the top of your paycheck -- is already pretty steep. Yet as the number of workers supporting each retiree dwindles and as retirees' benefits are continually adjusted upward for inflation, FICA will have to keep pace. Not a pretty prospect. Pyramid PropsSo what's the solution? There's no easy answers, especially for politicians hoping to be re-elected. Whatever position they take is sure to be attacked by a major constituency.Current retirees are strongly represented by the AARP. Most have paid into the system all their lives and stridently oppose any solution that would result in a benefit reduction. Current workers, however, oppose increases in the payroll tax -- especially since many of them doubt that Social Security will even be around when they retire. By the same token, they also don't want to risk any reduction in their potential benefits whether through lower payments or delayed retirement age. At this point, the easy solution is to do nothing and hope for the best. This seems to be the Democrats' approach and, in the short term, may be most politically expedient since it steps on no one's toes. The only thing is, the problem won't go away. As time goes by, the pyramid will continue to weaken and potential solutions will become fewer and more expensive. The second alternative, cutting benefits, would be a tougher sale. The AARP and politicians opposed to changing Social Security have whipped current recipients into a frenzy. With senior citizens representing a strong voting bloc, there's little chance any politician would ever support a reform that would draw their ire. As an alternative, President Bush's advisors appear to be supporting cutting the benefits of future retirees. This would occur in a roundabout fashion through a change in the method of indexing initial and future benefits.
Currently at retirement, a worker's initial benefits are based on wage inflation. Once calculated, this initial benefit serves as a base for future benefits which are then increased by so-called "wage indexing". The Bush plan would change this process by calculating the initial benefit using price inflation rather than wage inflation. Since wages have historically increased faster than prices, initial benefits and the subsequent ones based upon them, would grow at a slower pace. In fact, as time goes on, each future generation would receive a smaller percentage of its earnings. "Price indexing" would result in substantial future savings. According to the Wall Street Journal, Social Security Administration actuaries estimate those retiring around 2050 would receive benefits 32% lower than they would get under the current formula.
Today's workers don't have a strong lobby like seniors have with the AARP, yet once the details of this approach become more widely known, there's certain to be a growing degree of opposition. It is, after all, this generation that is bearing the increasing burden of funding Social Security. To cut their benefits -- no matter how discretely -- would certainly raise the issue of fairness. A third alternative is to continue raising payroll taxes as before. Currently workers and employers share the 12.4% burden, so it's hard to imagine raising it to any great extent. Some have suggested increasing the so-called "Wage Base", the maximum annual compensation subject to FICA. In 2005, this is set at $90,000, so any dollar you earn over that won't be taxed for Social Security. By raising (or eliminating) the Wage Base, higher paid workers will shoulder more of the current tax burden. As enticing as this might sound, it still won't save Social Security. First of all, it preserves the current Ponzi scheme format which will continue to require higher and higher payroll taxes for all current workers. Increasing the hit on the higher compensated may help forestall the problem, but all workers will eventually face higher payroll taxes. Secondly, ever-increasing taxes are never a good idea in a capitalist economy. Taxes, as even Keynesians admit, are a drag on economic growth so it stands to reason that ever-increasing taxes are an ever-increasing drag.
Thirdly, any solution that preserves the current Social Security Program minimizes its potential positive impact on the economy. Remember, pyramid schemes are simply income-transfer mechanisms, they don't create any real investment. They rob Peter to pay Paul without even the possibility of creating any capital in between. Out From UnderThat's why a fourth alternative -- privatization -- is perhaps the most appealing. President Bush has advocated a version of this which would allow current workers to divert a part of their payroll taxes into their own personal accounts. These could be invested in a limited menu of options including stocks and bonds. In exchange for this privilege, electing workers would agree to accept lower levels of guaranteed Social Security benefits when they retire. The advantages are obvious. First, even modest additions to such accounts can compound to substantial amounts over the course of a working career. Even if annual additions were limited to $1,000 -- the proposal currently being considered by the Bush administration -- there's the potential to offset a considerable portion of the future Social Security obligation. A second benefit, and one that has so far garnered less press, is that any move toward privatization is a step away from the current Ponzi scheme. Rather than simply attempting to support a collapsing pyramid, private accounts would actually introduce a true investment element into the system. Workers' retirement would no longer be totally dependent on the whims of the current crop of elected officials. Instead, they would actually have a real account balance not just a "trust fund" fantasy. Finally, private accounts would strengthen investment in the overall economy. As opposed to today's "pay-as-you-go" pyramid scheme, the the private account portion of employees' tax dollars would actually be invested in U.S. companies (stocks) or corporate and government debt (bonds). This, not government mandated wealth transfer programs, is what fuels a capitalist economy. Oddly enough, the AARP and the President's political detractors are strongly opposed to this approach. According to them, it's akin to letting Generations X and Y take Grandpa's meager retirement savings to Vegas. Stocks and bonds are "risky" and there's the chance they could lose it all, leaving the government with an even greater dilemma. This is an effective way to scare Grandma, but has little to do with reality. If they weren't politicians, those pushing it would probably be ashamed of themselves. (The AARP's support is harder to explain.)
Any system of private accounts would most certainly be limited to a small menu of stock and bond options, probably high quality index funds. Of course there's risk in the financial markets -- that's why they offer potential returns. That's not to say risk can't be controlled through diversification and other commonly understood tactics used by any successful long-term investor. Indeed, long-term investing can work for even the most unsophisticated investor. According to data from Ibbotson Associates, for the period 1926 - 2003, diversified portfolios of stocks and/or bonds haven't had a negative return in a single 20-year period. Chart 2 summarizes the results, showing the high, low, and average return for each series. As you'll notice from Chart 2, even the "riskiest" option, small cap stocks, never had a negative 20-year return. The actual 20-year return distribution is illustrated in Chart 3. If the future's like the past -- and there's no reason to expect it won't be -- private accounts wouldn't introduce an unacceptable level of risk for workers with at least twenty years to retirement. More importantly, the money put "at risk" isn't Grandma and Grandpa's. The introduction of private accounts is not necessarily tied in any way to a reduction of benefits for current retirees. Linking the two is a great way to make political points and build seniors' opposition, but it's not a necessary consequence. What is a problem with private accounts, is how to make up the shortfall they would initially generate. Any payroll taxes diverted into private accounts would reduce the amount available to pay current retiree's benefits. Private accounts are a good way to modify Social Security for future beneficiaries, but the pyramid will continue to collapse in the meantime. The Bush administration seems to favor more government borrowing to alleviate the shortfall, but with the nation's deficit already nearing record levels, this may not be a viable solution. Perhaps increasing the wage base may make more sense if combined with a private account option. Maybe (hopefully) there are other options available to close the gap. Regardless of the path ultimately taken, no solution will be easy. Everyone has a stake in this issue and no one wants to be shortchanged. Nevertheless, one thing is clear: As Carlo Ponzi discovered over eighty years ago, no pyramid scheme no matter how well constructed and sold, can avoid its ultimate collapse. Stop-gap measures to prop up Social Security will only delay but not change the inevitable. Any solution that introduces actual investment will not only benefit the system and its participants, but the overall economy as well. Search this site! Just enter you key word or words:
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MAGINE AN INVESTMENT THAT offers a lifetime of ever-increasing payments. Although initial investments are made over time, each and every investor immediately receives the right to future income streams. Further imagine that there really isn't any investment going on here, but rather a simple transfer of new investors' dollars to older investors.
