Why a Pay-As-You-Go System (Social Security) is not like a Ponzi scheme


The following excerpt comes from Mark Thoma’s post SSA Historical Research Note #25: Ponzi Schemes vs. Social Security:

The Logic of Pay-As-You-Go Systems In contrast to a Ponzi scheme, dependent upon an unsustainable progression, a common financial arrangement is the so-called “pay-as-you-go” system. Some private pension systems, as well as Social Security, have used this design. A pay-as-you-go system can be visualized as a pipeline, with money from current contributors coming in the front end and money to current beneficiaries paid out the back end.

There is a superficial analogy between pyramid or Ponzi schemes and pay-as-you-go programs in that in both money from later participants goes to pay the benefits of earlier participants. But that is where the similarity ends. A pay-as-you-go system can be visualized as a simple pipeline, with money from current contributors coming in the front end and money to current beneficiaries paid out the back end.

So we could image that at any given time there might be, say, 40 million people receiving benefits at the back end of the pipeline; and as long as we had 40 million people paying taxes in the front end of the pipe, the program could be sustained forever. It does not require a doubling of participants every time a payment is made to a current beneficiary, or a geometric increase in the number of participants. (There does not have to be precisely the same number of workers and beneficiaries at a given time–there just needs to be a fairly stable relationship between the two.) As long as the amount of money coming in the front end of the pipe maintains a rough balance with the money paid out, the system can continue forever. There is no unsustainable progression driving the mechanism of a pay-as-you-go pension system and so it is not a pyramid or Ponzi scheme…

I originally saw the excerpt on Brad DeLong’s blog in the article Social Security as a Non-Ponzi Scheme.  It is hard to identify who is writing and who is editorializing on things that come from Brad DeLong’s blog, so I post the trail here for those readers to whom it might make a difference.

To me the hallmarks of a Ponzi scheme are:

  1. Offering unbelievably high returns on an investment.
  2. Requiring a clearly impossible, perpetual, geometric increase in the number of new investors to sustain the unbelievable payouts to the earlier investors.

Given the claims of the detractors of Social Security that the retiree could get a better return by investing privately than by putting money into Social Security, Social Security is not offering unbelievably high returns. It is actually offering lower returns.  If allowed by the politicians to be run like a private pension system (not individual accounts invested at retail by the beneficiary),  Social Security could pay higher returns than it does now.

The number of new investors compared to earlier investors is known to rise and fall over the lifetime of Social Security, but there is no perpetual geometric increase (I just said sometimes it decreases), and yet the system is able to maintain stability for the foreseeable future.

So neither of these two major hallmarks of Ponzi schemes is present in the Social Security system.  These facts are clear even to the people who claim that Social Security is a Ponzi scheme.  What does that tell you about the people who make such claims?

If the detractors were clear (I can’t say “honest”) about their claims, they would be saying,

“Social Security is not a Ponzi scheme because it offers a substandard return on your investment. If that doesn’t make you want to opt out of Social Security, then you should know that Social Security is a Ponzi scheme.”

Then the judgment on their veracity would be easier to make.

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