Naturally, since this friday was the first time that the SB server has really been down since I start blogging (planned downtime, as it happens, for a major system upgrade), there
was spectacularly bad math in the local news here in NYC friday afternoon.
I’m not sure how long this has been the case, but Mayors of NYC have a radio show. It’s a mixture of them spouting off about whatever they feel like babbling about, and call-in questions. I don’t generally listen, but once in a while, if the mayor says something either particularly interesting or particularly insane, I’ll hear the segment repeated on the local NPR station.
In this friday’s show, he sprung a really shockingly stupid line. The supposed
topic was Bernard Madoff and his pyramid scheme. Bloomberg responded by saying
that “Madoff’s isn’t the biggest ponzi scheme ever. If you really want to see the
worlds biggest ponzi scheme, just look at social security.” He continued along
those lines for a few minutes.
This is, to put it mildly, bullshit. Incredibly, stupid, rampant, bullshit.
As usual, I’ll start with a bit of background to clarify things.
A Ponzi scheme is a particular kind of pyramid scam. It’s really a process for running a
scam. The way that it works is that you create some kind of “investment fund”. You promise
some kind of great payoff, and convince people to invest. As you get new investors, you use
their investments to pay off the previous investors, skimming off a layer from the top to
enrich yourself. The whole pyramid – the layers of investors paying off investors – is really just a front for what’s really going off – which is the manager of the Ponzo scheme
For example, you could start a Ponzi scheme by selling an “investment” with
a promised growth rate of 50%/year. Suppose you sold 10 $100,000 “shares” in your fund.
At the end of the year, you need to be able to pay $150,000 to each of your original
ten investors. So you get 20 people in invest – you’ve then taken in $2,000,000, and
you’ve paid out $1,500,000, which means you got to pocket a cool half-million dollars.
Of course, the next year, you need to enlist 30 new investors just to break even – so you’d get something like 40 – and pocket the money left after paying off the previous
year’s 20. And so on.
This works great for as long as you can rope in more investors. But eventually,
you’re going to get to the point where you can no longer bring in enough investors.
And the whole mess collapses, because there was nothing really there. There was
no business. There was no investment. There was just a scam to allow the people who
started it to cheat a lot of people out of a lot of money.
The whole idea of a Ponzi scheme is that you’ve got that pyramid – the ever-growing
pool of “investors” at the bottom, who are pouring money into the pool, and there’s a small group of people at the top, who are stealing money from the pool, while doing the Ponzi
payoff trick just to make the people at the bottom still keep pouring money in.
For those who haven’t followed it, Bernie Madoff is a famous New York
investment broker. He’s the former president of NASDAQ. It turns out that his
investment fund wasn’t really an investment fund – it was just a Ponzi scheme. He
managed to keep it going for an astonishingly long time. And it wasn’t
a well-hidden one – we was under suspicion for at least a decade, but
no one really bothered to investigate, because despite the fact that it looked
like a Ponzi scheme, acted like a Ponzi scheme, smelled like a Ponzi scheme, etc.,
no one could believe that a guy like Madoff would get involved in anything
Ok. So that’s background. Now Bloomberg is coming along and saying that Madoff’s
Ponzi scheme – the largest one in history – is nothing, because social security is
the same thing, but on a much bigger scale.
Why do I say that that’s bullshit?
The biggest reason is: social security isn’t an investment. It’s a government
social program that taxes wage-earners, and guarantees that every retired person
gets enough of a pension to allow them to get by. That might seem like a shallow
distinction – but it’s not. It’s incredibly important. The trick behind a Ponzi
scheme is that you lie to the people buying in to it. You tell them that
they’re investing their money, when you’re really just pocketing it.
Social security, from the day it started, has been a direct payment system – that is, it
levies a tax, and the revenue from that tax is used to pay the cost of the program. It’s not
a savings fund, it’s not a personal investment – it’s a tax program that provides a pension
by levying a tax. The original idea of it was to be a zero-balance program – each year, it
takes in as much in taxes as it needs to pay benefits, so that at the end of the year, the
balance is zero. It’s a system that deliberately operates on the edge of what would
be bankruptcy if it were a business! It constantly tries to ensure that it’s expected income
never exceeds its expected payments.
There’s a piece of it which looks Ponzi like: generation N+1 pays in to the system,
which pays the benefits for generation N. Each successive generation, when it retires,
collects benefits based on money paid in to the system by the next generation. But remember that the point of the Ponzi is to (A) trick people into thinking that they’re
making an incredibly profitable investment, and (B) skim a huge amount of money for yourself from the top. That’s not what social security does, at all. It’s a zero-balance
In practice, maintaining the zero-balance gets complicated, and the complications can
make it appear, in some ways, to look a bit like an investment – but it’s important to keep
in mind that it’s not. As I said above, the idea is to make expected payments match
expected income. The expected payments are the amount of money that conservative
projections predict will be needed to provide a basic living-wage pension to every retired
person. The expected income is the total amount of money collected as taxes from
wage-earners, and any income earned by investing that money. It’s not really run on
a year-to-year balance method, because that wouldn’t work well. The government actuaries and
accountants who administer the program, being the kinds of meticulous people that actuaries
and accountants typically are, naturally realize that demographics make this complicated: the
ratio of the number of people paying social security to the people collecting
benefits isn’t constant. In fact, there are some bulges – that is, generations of
people that are larger than average. When they retire, the payments out of the program are
going to be disproportionately large. But before they retire, the number of people paying
into the program will be equally disproportionately large.
Instead of constantly changing the social security tax rate – lowering it when the
large generation is paying in, and raising it when they’re drawing out, it makes a lot
more sense to set the rate so that they take in excess for a demographic bubble,
they put the excess away, and save it. Then when that bubble retires, the social security administration will have the excess money that they saved away to pay the benefits. If you look at that, you can see it looking sort of like an investment. You pay social security taxes, and right now (as we head towards the end of one of those demographic bubbles),
most of the money that you pay is invested by the government into federal treasury bonds. So the money that’s being paid into SS by you is, mostly, being invested. But it’s not the case that your SS money is being invested for you. It’s being used to pay current benefits – and saved to pay off the next generation of benefits – which is, most likely, not yours. Your SS benefits will be paid by taxes paid by the next generation of
taxpayers. That’s the way it works, by design.
You don’t have any money saved or invested in social security. It’s not a savings
account, or an investment account. It’s a tax that’s used to pay benefits. And there’s
no one making a profit by stealing money from the social security.
It’s not a Ponzi scheme. It’s a zero-balance tax-funded benefit system. The similarity
between SS and a Ponzi is that at any moment in time, the people paying in to the system are different from the people who are cashing out – and the first generation of people who collected money from SS didn’t pay in to it at all. At any point in time, generation N+1 is paying the benefits for generation N.
There are philosophical and political arguments against social security. Personally, as a
liberal, I find most of them rather unconvincing. But my opinion is beside the point. If someone like Michael Bloomberg doesn’t like Social Security, he should have the guts to be
honest about why. Bloomberg is no dummy – especially when it comes to finances. He knows how it works. He knows that calling it a Ponzi scheme is an out-and-out lie. But he’s willing to tell that lie.