Monday, January 5, 2009

Ponzi Schemes and Social Security

Lately I've been reading quite a bit about the Madoff scandal. In case you have not yet heard, Bernie Madoff, a previously well-respected money manager and former chairman of the NASDAQ stock exchange, is accused of operating a gigantic Ponzi scheme since the late '70s, resulting in losses to his clients now of around $50 billion.

The basic idea of a Ponzi scheme is fairly simple. The operator of the scheme pays his old investors returns out of money he takes from new investors, rather than out of profits. Mr. Ponzi takes on investor A as a client, usually promising him a fairly high return on his money in order to entice him to enter the scheme. Then, when Mr. Ponzi needs to pay that investor his money back, he does so not out of the profits he makes on any trades he has transacted, but out of the money brought in by new investors. This is essentially robbing Peter to pay Paul, but with a twist: Mr. Ponzi pockets all the money he can without the investors noticing it.

Ponzi schemes can become complicated, and Madoff obviously found ways to disguise what he was doing for a long time. Madoff's firm had several branches, not all of which were tied into this Ponzi scheme, and Madoff undoubtedly tried to cover his crimes with legitimate trading activity. He also was careful not to offer his investors absurdly high returns which would be sure to set off red flags.

Nevertheless, Ponzi schemes are doomed to failure, and failed in Madoff's case, when in the midst of an economic downturn investors withdraw their money from the scheme. Thus, essential to the ongoing success of a Ponzi scheme is the growing pool of investors. Madoff of course knew this, and recruited heavily.

All this brings me to my question: How exactly does Social Security differ from a Ponzi scheme? I fail to see any essential difference between the two. In social security the government collects money from its "investors" (i.e., tax-payers) and promises to set it aside and pay it out again in the future. In the meantime, what do they do except raid an account that is supposed to be kept in trust? Moreover, Social Security is having the same classic problem that faces all Ponzi schemes: not enough new money coming in. In the case of Social Security, the generation that is going to retire in the near future did not raise enough children. So, when they retire they will demand to withdraw their money, but there will not be enough young people paying into Social Security.

I hope I am wrong about this, and I very well may be mistaken about some of the details, but I do believe that I have the essentials right.
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