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Ponzi Schemes for Beginners

Monday, 12 September 2011 08:37 By James Kwak, The Baseline Scenario | News Analysis

On the theory that the best defense is a good offense, Rick Perry has been insisting to anyone who will listen that Social Security is a Ponzi scheme. Probably hundreds of people have already explained why it isn’t, but I think it’s important to be clear about why Rick Perry thinks it is—or, rather, why his political advisers think he can get away with it.

A Ponzi scheme, classically, is one where you promise high returns to investors but you have no way of actually generating those returns; instead, you plan to pay off old investors by getting new money from new investors. Social Security is obviously not a Ponzi scheme for at least two basic reasons. First, there’s no fraud involved: all of Social Security’s finances are right out in the open for anyone who cares to look, in the annual report of the trustees of the Social Security trust funds. Second, a Ponzi scheme by construction cannot go on forever; no matter how long you can keep it going, at some point you will run out of potential new investors and the whole thing will collapse. I’m sure there are other obvious differences, but that’s enough for now.

So why do people ever think it’s a Ponzi scheme? It’s the combination of two factors, each of which is relatively innocuous on its own.

First, Social Security is, from a cash flow perspective, a pay-as-you-go system. That is, payroll taxes being paid by current workers are immediately going out the door to pay benefits for current retirees. This is different from a pre-funded pension system where the pension plan already has enough money, today, to pay for all promised future benefits. Employer-sponsored pension funds in principle (though not always in practice) work this way: at any moment, the fund is supposed to have enough money to pay off future benefits. A commenter on an earlier post of mine said that if Social Security were a corporate pension fund, I would be attacking it as a fraud for this reason.

Not so fast. There’s nothing wrong in principle with a pay-as-you-go system, as long as the future revenue stream is secure. With any pension plan, the fundamental question is whether the plan will be able to pay future promised benefits. We want private pensions to be pre-funded because we wouldn’t trust a company that said, “We know we don’t have enough money to pay the benefits we promised, but don’t worry, we’ll be really profitable starting twenty years from now, so we’ll be fine.” It’s not a question of whether corporate executives are honest; it’s that the future is uncertain. As we know, companies can go bankrupt almost overnight (remember Enron? WorldCom?), so the only way to ensure that they will pay future benefits is to require pre-funding. Even then, pre-funding is not a magic bullet because you have to make some assumption about future investment returns. Under today’s rules, companies assume some rate of return on their pension fund investments (actually, I think they assume some discount rate for their future liabilities, which works out to roughly the same thing)—which means that even with pre-funding, there’s no assurance the money will be there to pay benefits.

Social Security is different because it knows that, unlike future corporate profits, the trust funds’ revenues will be there in future years. That’s the great thing about being the federal government: you know people will pay their taxes. Yes, there is uncertainty about economic growth, but Social Security’s future income stream is a good deal more predictable than a corporate pension fund’s future investment returns.*

But, you may be saying, and this is the second factor, the trust funds will go bankrupt in about twenty-five years!** That is probably true, but it is not because Social Security is a pay-as-you-go system. A pay-as-you-go system can easily go on forever, as long as you have a constant rate of population growth (or even a constant rate of population decline): Generation A’s benefits are paid by Generation B, which is 10 percent larger than Generation A; Generation B’s benefits are paid by Generation C, which is 10 percent larger than Generation B; and so on. With a few more simple assumptions, this can go on forever.

The Social Security trust funds will run out of money because the current structure of taxes and benefits requires a certain minimum dependency ratio (the ratio of workers to retirees) and the actual dependency ratio will fall below that required minimum as the Baby Boom generation retires. It’s the combination of those two facts—that Social Security is a pay-as-you-go system and that the trust funds will run out of money—that makes Rick Perry thinks it’s a Ponzi scheme. Ponzi schemes are also pay-as-you-go systems that will run out of money, but that doesn’t make Social Security a Ponzi scheme, just like all giraffes are mammals, but not all mammals are giraffes.

As all informed observers realize, you could close the seventy-five-year Social Security budget gap simply by raising the payroll tax rate by two percentage points (or by other means that have a similar financial impact, such as eliminating the cap on taxable income). This in itself should make clear that it isn’t a Ponzi scheme.

Now, it is true that the benefit-tax structure was already changed in 1983, so it’s a reasonable question whether the system has to be “fixed” every thirty years, which would raise the question of sustainability. But there’s no good reason to think the dependency ratio will keep getting worse and worse, because the Baby Boom was a one-time historical event. Right now the dependency ratio and the funding gap are expected to level off around 2035 (as the last Baby Boomers retire) and remain roughly flat for half a century. (See the 2011 annual report, pp. 10–11.) So any policy change that brings Social Security in balance in 2035 will keep it more or less in balance as far as we can see. Yes, it’s possible that the birth rate could drop again, but it could also go up; we just don’t know. (And if the birth rate drops, what that means is that we need more immigration by working-age people, but that’s another topic.)

Wait, Rick Perry might say: Doesn’t the fact that we all know Social Security’s future revenues are not enough to pay its scheduled benefits make it a fraud all by itself? Not in a legal sense, since all the information is out there for everyone to see. But it does raise a legitimate issue: By 1983, the Baby Boom had happened, so everything that is going to happen with the dependency ratio was easily predictable—yet Congress and the Reagan administration consciously underfunded the system.  (As of 1983, Social Security was in 75-year actuarial balance, but that was because a large surplus in the first thirty-seven years balanced a large deficit in the last thirty-eight years. See the 1983 Annual Report Summary, Chart F.) Isn’t that a problem?

But saying that Congress underfunded Social Security is not a valid criticism of Social Security as a program: it’s a valid criticism of Congress. As a logical matter, you can criticize our political leaders, past and present, for not fixing Social Security’s long-term funding problem, but you can’t use that fact to criticize the basic structure of the system, where people pay taxes while working and receive benefits while in retirement. There’s nothing wrong with that, try as Rick Perry might to confuse the issue.

* Private accounts would solve this problem, but not in a useful sense. Because you would only be entitled to the money in your private account, Social Security would have no obligations, and hence could never be underfunded. But you would be subject to inflation risk and investment risk; today, Social Security absorbs both inflation risk and investment risk, so all you are subject to is political risk (the risk that benefits when it comes time for you to collect them).

** “Bankrupt” isn’t quite right: what will happen is that the trust funds’ accumulated balance will run down, so the only money they will have to pay benefits will be the current year’s payroll tax revenues—which will not be enough to pay scheduled benefits. It’s not clear that these “scheduled” benefits should even count as “promised,” since both the law and the financial status of Social Security are public information, but that’s another topic for another time.


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Ponzi Schemes for Beginners

Monday, 12 September 2011 08:37 By James Kwak, The Baseline Scenario | News Analysis

On the theory that the best defense is a good offense, Rick Perry has been insisting to anyone who will listen that Social Security is a Ponzi scheme. Probably hundreds of people have already explained why it isn’t, but I think it’s important to be clear about why Rick Perry thinks it is—or, rather, why his political advisers think he can get away with it.

A Ponzi scheme, classically, is one where you promise high returns to investors but you have no way of actually generating those returns; instead, you plan to pay off old investors by getting new money from new investors. Social Security is obviously not a Ponzi scheme for at least two basic reasons. First, there’s no fraud involved: all of Social Security’s finances are right out in the open for anyone who cares to look, in the annual report of the trustees of the Social Security trust funds. Second, a Ponzi scheme by construction cannot go on forever; no matter how long you can keep it going, at some point you will run out of potential new investors and the whole thing will collapse. I’m sure there are other obvious differences, but that’s enough for now.

So why do people ever think it’s a Ponzi scheme? It’s the combination of two factors, each of which is relatively innocuous on its own.

First, Social Security is, from a cash flow perspective, a pay-as-you-go system. That is, payroll taxes being paid by current workers are immediately going out the door to pay benefits for current retirees. This is different from a pre-funded pension system where the pension plan already has enough money, today, to pay for all promised future benefits. Employer-sponsored pension funds in principle (though not always in practice) work this way: at any moment, the fund is supposed to have enough money to pay off future benefits. A commenter on an earlier post of mine said that if Social Security were a corporate pension fund, I would be attacking it as a fraud for this reason.

Not so fast. There’s nothing wrong in principle with a pay-as-you-go system, as long as the future revenue stream is secure. With any pension plan, the fundamental question is whether the plan will be able to pay future promised benefits. We want private pensions to be pre-funded because we wouldn’t trust a company that said, “We know we don’t have enough money to pay the benefits we promised, but don’t worry, we’ll be really profitable starting twenty years from now, so we’ll be fine.” It’s not a question of whether corporate executives are honest; it’s that the future is uncertain. As we know, companies can go bankrupt almost overnight (remember Enron? WorldCom?), so the only way to ensure that they will pay future benefits is to require pre-funding. Even then, pre-funding is not a magic bullet because you have to make some assumption about future investment returns. Under today’s rules, companies assume some rate of return on their pension fund investments (actually, I think they assume some discount rate for their future liabilities, which works out to roughly the same thing)—which means that even with pre-funding, there’s no assurance the money will be there to pay benefits.

Social Security is different because it knows that, unlike future corporate profits, the trust funds’ revenues will be there in future years. That’s the great thing about being the federal government: you know people will pay their taxes. Yes, there is uncertainty about economic growth, but Social Security’s future income stream is a good deal more predictable than a corporate pension fund’s future investment returns.*

But, you may be saying, and this is the second factor, the trust funds will go bankrupt in about twenty-five years!** That is probably true, but it is not because Social Security is a pay-as-you-go system. A pay-as-you-go system can easily go on forever, as long as you have a constant rate of population growth (or even a constant rate of population decline): Generation A’s benefits are paid by Generation B, which is 10 percent larger than Generation A; Generation B’s benefits are paid by Generation C, which is 10 percent larger than Generation B; and so on. With a few more simple assumptions, this can go on forever.

The Social Security trust funds will run out of money because the current structure of taxes and benefits requires a certain minimum dependency ratio (the ratio of workers to retirees) and the actual dependency ratio will fall below that required minimum as the Baby Boom generation retires. It’s the combination of those two facts—that Social Security is a pay-as-you-go system and that the trust funds will run out of money—that makes Rick Perry thinks it’s a Ponzi scheme. Ponzi schemes are also pay-as-you-go systems that will run out of money, but that doesn’t make Social Security a Ponzi scheme, just like all giraffes are mammals, but not all mammals are giraffes.

As all informed observers realize, you could close the seventy-five-year Social Security budget gap simply by raising the payroll tax rate by two percentage points (or by other means that have a similar financial impact, such as eliminating the cap on taxable income). This in itself should make clear that it isn’t a Ponzi scheme.

Now, it is true that the benefit-tax structure was already changed in 1983, so it’s a reasonable question whether the system has to be “fixed” every thirty years, which would raise the question of sustainability. But there’s no good reason to think the dependency ratio will keep getting worse and worse, because the Baby Boom was a one-time historical event. Right now the dependency ratio and the funding gap are expected to level off around 2035 (as the last Baby Boomers retire) and remain roughly flat for half a century. (See the 2011 annual report, pp. 10–11.) So any policy change that brings Social Security in balance in 2035 will keep it more or less in balance as far as we can see. Yes, it’s possible that the birth rate could drop again, but it could also go up; we just don’t know. (And if the birth rate drops, what that means is that we need more immigration by working-age people, but that’s another topic.)

Wait, Rick Perry might say: Doesn’t the fact that we all know Social Security’s future revenues are not enough to pay its scheduled benefits make it a fraud all by itself? Not in a legal sense, since all the information is out there for everyone to see. But it does raise a legitimate issue: By 1983, the Baby Boom had happened, so everything that is going to happen with the dependency ratio was easily predictable—yet Congress and the Reagan administration consciously underfunded the system.  (As of 1983, Social Security was in 75-year actuarial balance, but that was because a large surplus in the first thirty-seven years balanced a large deficit in the last thirty-eight years. See the 1983 Annual Report Summary, Chart F.) Isn’t that a problem?

But saying that Congress underfunded Social Security is not a valid criticism of Social Security as a program: it’s a valid criticism of Congress. As a logical matter, you can criticize our political leaders, past and present, for not fixing Social Security’s long-term funding problem, but you can’t use that fact to criticize the basic structure of the system, where people pay taxes while working and receive benefits while in retirement. There’s nothing wrong with that, try as Rick Perry might to confuse the issue.

* Private accounts would solve this problem, but not in a useful sense. Because you would only be entitled to the money in your private account, Social Security would have no obligations, and hence could never be underfunded. But you would be subject to inflation risk and investment risk; today, Social Security absorbs both inflation risk and investment risk, so all you are subject to is political risk (the risk that benefits when it comes time for you to collect them).

** “Bankrupt” isn’t quite right: what will happen is that the trust funds’ accumulated balance will run down, so the only money they will have to pay benefits will be the current year’s payroll tax revenues—which will not be enough to pay scheduled benefits. It’s not clear that these “scheduled” benefits should even count as “promised,” since both the law and the financial status of Social Security are public information, but that’s another topic for another time.


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