From Ponzi to Perry: The Truth about Social Security

By Andrew G. Biggs

Let us count the ways in which Social Security is and is not like a Ponzi scheme.

From the left to the right, political commentators are piling onto Texas Governor Rick Perry for calling Social Security a “Ponzi scheme.” Perry’s competitors for the Republican presidential nomination are overjoyed at an opening against the new front-runner, with former Massachusetts Governor Mitt Romney calling Perry “reckless and wrong on Social Security.” Romney’s campaign alleged that the Texas governor “believes Social Security should not exist.” Even the ordinarily white-hot conservative Michele Bachmann has gotten in on the act, calling it “wrong for any candidate to make senior citizens believe that they should be nervous about something they have come to count on.”

Perry has responded with a USA Today op-ed on Social Security, stressing the need to reform the system. But, like another recent Texas governor, Perry has the weakness of saying what he thinks without adequately explaining what he says. This doesn’t mean he’s wrong—as I’ll explain, there’s a lot that’s right about Perry’s claims—but it unnecessarily exposes him to attacks. That’s why I don’t call Social Security a Ponzi scheme; incendiary language can cloud whatever substantive point you’re trying to make. Nevertheless, I’ll try to sort a few things out.

In both Social Security and a Ponzi scheme, early participants receive payments, not from interest on their own investments, but directly from inflows from later participants.

To begin, Perry questions whether the Framers would even have considered Social Security to be constitutional. This sounds a bit wacky in today’s context, but his claim is almost certainly true. Even the Roosevelt administration was worried that Social Security wouldn’t pass constitutional muster, going so far as to delink taxes from benefits—that is, to eliminate the ownership right in benefits that Roosevelt thought so important—in order to bypass the objection that the federal government had no constitutional authority for a federally run insurance plan.

As the Social Security Administration's history of the constitutional question makes clear, even this may not have been enough to get the Social Security Act passed by the Supreme Court without a little bit of presidential intimidation. Prior to the Social Security case, Roosevelt threatened to “pack the Court” with additional justices more to his liking. Roosevelt’s plan failed but, as the SSA history notes,

The Court, it seemed, got the message and suddenly shifted its course. Beginning with a set of decisions in March, April, and May 1937 (including the Social Security Act cases) the Court would sustain a series of New Deal legislation, producing a "constitutional revolution in the age of Roosevelt."

In other words, the Supreme Court ruling validating Social Security's constitutionality isn’t exactly how any of us would like court rulings to happen. Nevertheless, as Perry has noted, this is water under the bridge now. He isn’t (and shouldn’t be) seeking to re-fight a 65-year-old constitutional battle. But to think Perry’s constitutional claims are wrong is, well, wrong.

Romney himself wrote that Social Security resembles a ‘fraudulent criminal enterprise.’ Reid called borrowing from the Social Security trust fund ‘embezzlement, thievery.’

But now to the Ponzi comparisons. To be clear, these aren’t a Perry original. As Perry’s campaign pointed out, Romney himself wrote that Social Security resembles a “fraudulent criminal enterprise.” Which enterprise might he have been thinking of? Likewise, Senate Majority Leader Harry Reid called borrowing from the Social Security trust fund “embezzlement, thievery,” saying that if he had done this in the private sector “I could be criminally prosecuted by the district attorney.” So the Texas governor is far from alone in his comments.

But why a Ponzi scheme? The distinguishing characteristic of a Ponzi scheme is its intent to defraud. Charles Ponzi, and his modern cousin Bernie Madoff, meant to rip people off. Whatever disagreements we may have over policy, no one believes that FDR meant to rip people off, and neither do modern liberals who wish to maintain the program.

But most of those who refer to Social Security as a Ponzi scheme are not thinking intent so much as effect. What makes the Social Security/Ponzi references so common is the similarity in the way they are financed. In both cases, early participants receive payments, not from interest on their own investments, but directly from inflows from later participants. If you were describing the mechanics of how Social Security’s financing works, it wouldn’t be illogical to refer to a Ponzi scheme.

Perry questions whether the Framers would even considered Social Security to be constitutional.

And, also like a Ponzi scheme, Social Security paid early participants incredible returns on their money, because they contributed to the system for only a few years but received a full retirement’s worth of benefits. A person who retired in 1950 received around a 20 percent annual return on the taxes he paid (which happens to be exactly the same return that Madoff promised to his investors). Put another way, that person received around 12 times more in benefits than he’d paid in taxes. That helps explain why Social Security became so popular: it was simply an incredibly good deal.

If you were born in 1950 and heard your grandparents say how much they liked Social Security, you’d be tempted to think you’ll get the same sort of deal. But you won’t: an average wage earner born in 1950 will receive around a 2.2 percent return from the system, which is less than what you could earn on guaranteed government bonds. A person entering the workforce today will receive only around a 1.7 percent return. In effect, Social Security’s reputation is based off a deal that it can no longer deliver. Whatever good it did in the past—and it did do a lot of it, in terms of reducing poverty and helping the disabled and survivors, in the process undercutting Perry’s claims that Social Security was “by any measure” a failure—it will do less of it in the future.

Similarly, like a Ponzi scheme, there really isn’t any actual investment going on with Social Security. While the trust fund has a $2.5 trillion balance it can call on to pay benefits, this fund won’t be of any help to the taxpayer. When Social Security goes to redeem bonds in the trust fund, the Treasury must raise taxes, cut other programs, or borrow the money—exactly the same steps as if there weren’t a trust fund at all. The trust fund records how much we have borrowed from Social Security but, as the Congressional Budget Office points out, “trust fund balances convey little information about the extent to which the federal government has prepared for future financial burdens.” While legally important, the CBO says, the trust fund has “little economic meaning.”

Perry has the weakness of saying what he thinks without adequately explaining what he says.

The biggest difference may be that Social Security can go on forever while a Ponzi scheme can’t, but that’s mostly because Social Security can force you to participate. If Madoff could find enough people willing to accept a 2 percent return rather than a 20 percent return, his plan could keep going indefinitely. With Social Security participation mandated, the program can go on forever, so as long as Congress makes the changes necessary to keep the system from going broke.

Which, in the end, is what Perry and the other presidential candidates—including President Obama, I might add—should be talking about. Whether Social Security was constitutional and whether its pay-as-you-go financing structure is optimal, we’ve got what we’ve got. A differently designed Social Security system in 1935 might have produced better outcomes today and in the future, but we can’t turn back the clock. We have to deal with the system we have and figure out how to make it solvent and how to make it work better in the future. (For my part, I put together a proposal for the American Enterprise Institute as part of a larger budget project for the Peter G. Peterson Foundation.) Instead of arguing about what’s wrong with Social Security, we should be thinking about how to put things right.

Andrew G. Biggs is a resident scholar at the American Enterprise Institute.