“Investments” that pay profits not from capital gains but from new investor money are often referred to as Ponzi schemes. They are named after Charles Ponzi who ran an investment scheme in which he promised to provide investors with a 50% return on postage return coupons within a short period of time. While the investment might have been viable instead of using capital gains he paid off old investors with new investor funds. Ponzi’s “investment” scheme worked very well until one day no more new investors provided him with funds and consequently he could no longer provide returns to the older investors and the pyramid scheme fell apart.
Charles Ponzi went to jail for defrauding his investors and it is still against the law to run Ponzi schemes. The Federal Trade Commission states the following on its web site:
“Both Ponzi schemes and pyramids are quite seductive because they may be able to deliver a high rate of return to a few early investors for a short period of time. Yet, both pyramid and Ponzi schemes are illegal because they inevitably must fall apart. No program can recruit new members forever. Every pyramid or Ponzi scheme collapses because it cannot expand beyond the size of the earth’s population. When the scheme collapses, most investors find themselves at the bottom, unable to recoup their losses.
A Ponzi scheme is closely related to a pyramid because it revolves around continuous recruiting, but in a Ponzi scheme the promoter generally has no product to sell and pays no commission to investors who recruit new “members.” Instead, the promoter collects payments from a stream of people, promising them all the same high rate of return on a short-term investment. In the typical Ponzi scheme, there is no real investment opportunity, and the promoter just uses the money from new recruits to pay obligations owed to longer-standing members of the program. In English, there is an expression that nicely summarizes this scheme: It’s called “stealing from Peter to pay Paul.”
Although you or I would be arrested for running such a scheme, the U.S. Government has been getting away with it for nearly a century. As part of the New Deal, President Franklin D. Roosevelt signed the Social Security Act into law. The U.S. Social Security Program is the largest Government program in the world and accounts for approximately one third of total U.S. Government spending. The problem with the current Social Security System is that it pays out more than it takes in and as such it is no different than Ponzi’s scheme that used new participants to pay out old claims. The problem in both cases is that the payouts exceed incoming cash flow at an ever increasing rate as the number of contributors decrease relative to those expecting a return.
The flaws in the Social Security System were apparent with the first beneficiary. Ida Fuller of Vermont was the first recipient of a Social Security check. Just as the initial investors in Charles Ponzi’s scheme were thrilled to have made more than they contributed so was Ida Fuller. Having paid only $24.75 into the Social Security Fund over three years she received her first check on January 31, 1940 in the amount of $22.54. Her first check almost equaled the total amount she contributed and she lived to be a 100 years having collected a total of $22,888.
As if it weren’t enough that the Social Security System in itself is flawed, the many Presidents throughout history have borrowed against the Social Security Fund to increase their ability to spend above the Nation’s means while leaving the SS Fund a giant IOU.
2010 was the first year the fund paid out more than it received, putting additional pressure on future budgets and more uncertainty on whether those currently paying in will ever see their money back.
Today Treasury Secretary Geithner spoke about the problems the Social Security System is facing. He rightfully acknowledged that the budget problems the United States is facing cannot be merely attributed to the results of the financial crisis. Geithner further stated that restoring fiscal responsibility will require
“real sacrifices that affects all Americans… However, we will reject plans that slash benefits; that fail to protect current retirees, people with disabilities and the most vulnerable; or that subject Americans’ retirement savings to the whims of the stock market.”
That’s exactly the reason the United States is posting records deficits. Nobody is willing to reduce any government programs, nobody is willing to make the cuts necessary to balance the budget and most politicians in both parties are increasing the size, role, and spending of Government to “solve” economic problems. Today’s economic uncertainties have been perpetuated by both parties and their interventionist policies that grew the size, role, and spending of Government in an attempt to delay economic corrections. By avoiding economic corrections for many decades the United States has allowed its problems to grow bigger in size and the only solution presented by every Administration has been to further debase the monetary system and to continue on with the same policies that got us here in the first place.