Saturday, 5 September 2009

Social security - a disagreement with Peter Schiff

I just saw this YouTube video in which Peter Schiff, Max Kaiser, Ron Paul all criticized the US social security system as a Ponzi scheme. Now I agree that it is a Ponzi scheme - but that's not necessarily bad! And here's why...

First of all I will describe a bad Ponzi scheme and then explain how a slight tweak can make it good.

Imagine I set up a financial institution or "retirement club" for people on average earnings. My advertising states - "save 20% of your income with us for 40 years, then on retirement we'll pay out a 'pension' which will have grown in line with national average earnings". Say I limit the club to exactly 1000 members. During the initial 40 years I need not invest a single cent of the money that was coming in - I could even spend it all on a luxury lifestyle. But when people started retiring I would, at that point, have to stop my extravagant spending and simply start paying the retired people the money that was coming in from the working savers. This "Ponzi scheme" is now no longer working to my benefit. I'll get nothing from now on. Over the years the amount of money paid out would automatically adjust in line with wages because the money coming in is always a fixed fraction of the (working) club members earnings. Now, ignoring the problem of what I live on, this is now a stable state and could continue indefinitely so long as I could always keep the membership fully subscribed. This is a bad, dangerous scheme for my members however because if at some point I failed to find new members then the retirees would lose everything - a disaster.

Now for the tweak. Imagine that this exact same scheme is run by the government. Imagine that instead of a 1000 member club, it is now a membership of "the entire nation". Now it is guaranteed that there will always be new members. Now the one flaw in the "Ponzi" scheme has disappeared. It is no longer a bad scheme! It works! It can go on forever! No problem!

I wrote a related article about pensions a few months ago here.


  1. Hello,

    I am afraid you do not understand what a Ponzi scheme is. You assume that the money you collect will be enaugh to pay the retirees. This idea does not take in account the possible lower number of members (aging population!). It does not take in account any risk that may cause slight instability in the system. This is why Ponzi schemes always fail eventually. And this way of thinking i sexactly how one sells a Ponzi to the laymen. It relies on unlimited population and economic growth. I thought we have seen the end of that kind of thinking but looks like I was wrong.

  2. If you read my additional article (linked to at the bottom of this entry) you will see that I have addressed your precise point.

  3. If you are right Social security would not have had 5 billion dollar deficit in August alone. It is a terrible system. Look at all the projections for Social security, its broke. Where are the jobs to tax?

  4. You are misunderstanding a ponzi scheme.

    "...we'll pay out a 'pension' which will have grown in line with national average earnings..."

    "...simply start paying the retired people the money that was coming in from the working savers.."

    What about when what you are obliged to pay out is MORE than what you are bringing in? That's when the scheme unravels and you can't "simply start" paying out anything.

    If you invest the initial capital and make the required % that you need every year to meet your payment obligations, then it isn't a ponzi scheme but a simple investment plan like a bank account.

    Once you promise to make payments in the future which are likely more than the rate of return that you can obtain on the money, then you must attract more and more members each year to make up the difference. Note: you can't just replace old members with new, you need to do that and then also get new members.

    This can't go on for ever as you will eventually run out of members.

  5. "What about when what you're obliged to pay is more than what you're bringing in?". Well the key thing here is specifying what you're obliged to pay. Take a look at my original pensions blog entry (linked to at the end of this one) for an explanation of that point.

  6. "The money is not distributed evenly amongst retired people, instead it is (roughly speaking) distributed in proportion to the amount of money those retired people fed in to the elderly-support system during their working lives."

    This is basically your suggested algorithm for distributing the money? That the total amount is in proportion to what they put in is beside the point.

    Say the scheme holds capital C at some given year. The payouts that year can either be:

    - less than the yearly rate of return on capital C, which means the person would have been better investing the money himself.
    - more than the yearly rate of return on capital C, in which case you have to either have
    * a better rate of return on your money than most people or
    * have to use the input of current joiners of the scheme (which you still "owe" at some point) or
    * have to dip into the initial capital to make your payments (which you will also owe at some point).

    The scheme could move between these year to year but in the long run, one or other will dominate and mean either you
    *have no members because they're better investing the money themselves or
    * have lots of members and lots of money but rely on being Warren Buffet (not impossible but hard) or
    * an ever increasing sign up rate.

  7. You've mis-understood. There is no "capital" needed in my scheme at all. The system is "workers now pay to fund retirees now". The whole capital thing is a charade.

  8. Sorry, I presumed that you were saying it was profitable for the subscribers, in which case you have to take the "charade" of capital into account otherwise you are trying to build a perpetual motion machine.

    I presumed this as there is really nothing to discuss otherwise, as then what you are saying has nothing to do with ponzi schemes. if you're saying that this will work simply because the govment forces me to join, and i get back my proportion of whatever is put in by the members at the time of repayment, whatever that is. then yes this will continue for a long time (not for ever, countries don't last for ever).

    But so what? "The govermnent can pass laws to make you hand them money" is not a discovery.

  9. >But so what? "The govermnent can pass
    >laws to make you hand them money" is
    >not a discovery.

    Well it appears not to be known by Peter Schiff.

  10. You should open yourself to the idea that Peter Schiff might not be an idiot and might in fact be correctly using the phrase "ponzi scheme" as it is generally understood. It has been used for 80 years because it actually describes something specific and you might try to think exactly what it is.

    As I said above in my comment which you said was a “charade”, if the government is promising only to return a proportion of what is taken in, then your scheme is fine – it essentially just describes the taxation system, and it not profitable for the subscriber. It could carry on for a long time (not for ever though). This is not news.

    However, this is NOT what Peter Schiff is describing. Social Security payments-out are not just a proportion of whatever is being taken in at that time – the payouts are calculated independent of the contemporary payments-in. My understanding is that the payments-out overtook payments-in in 1974, but the exact date is unimportant – the point is, if the payouts promised exceed the rate of return that is achievable from the initial capital, then this date MUST occur. This sounds like a good deal to the subscriber (this is why ponzi schemes get off the ground) and can survive for a while longer while the subscriber base is growing - but once the growth stops, it’s sharply downhill. Then you have obligations you can’t meet.

    Peter Schiff is saying that the social security system has obligations it can’t meet. If it could just dole out a proportion of what it is getting in, then yes the problem goes away – but again, “if you change the terms of the agreements we can get out of this hole” is not news.

    It’s no good denouncing my discussion of capital and interest, it is fundamental. You have a background in physics – it’s like describing an engine using the heat sink, cold sink and entropy. These factors capture the fundamentals and many deductions can be made from them – and when you can’t formulate your question about an engine in these terms, then you don’t understand it.

  11. The exact nature of whats going on is tied up in the small print of how the level of payouts for social security/medicare etc are formulated. And I do not profess to be an expert on that. But I have no doubt they can chage the small print in the future. My main point is that it is possible to have a government run scheme that at first glance (and given a misleading presentation of how it works) **looks like** an unsustainable ponzi scheme but is in fact benign and sustainable.