Note: This post got a lot longer than I intended but I drifted into addressing a lot of issues. I hope it is not too painful.

 

I want to stick with this Social Security is a Ponzi Scheme theme for a while because it brings out many of my long standing points.

 

First, is people fundamentally not getting the nature of finance and confusing real assets with claims on real assets. This is what I am trying to bring out in my stories about Allen Stanford’s Ponzi Scheme and Apple Computer.

People think one is “fake” and the other is “genuine” but in both cases what you have is a financial asset, a promise. And, a promise is only ever as good as the intention of the people making it. Allen Stanford had no intention of making sure he made good on his promises.

In a similar vein I would argue that Apple has no intention of making good on the implicit promise to transfer profits to shareholders. That Sir Allen used investor money to party in Antigua and Apple used it to revolutionize consumer electronics is an important social difference but its not an important difference for the investor.

In neither case do they have any intention of acting in the best interest of their investors. And, further what allows them to get away with this is the power of their reputation. Sir Allen was knighted. Steve Jobs could be beatified if it went to a vote of the American people. Absent a crisis there is no way that investor claims are going to be honored by a democratic state against such popular men.

 

Second, the long standing problem of affect. Ponzi scheme is a term that is supposed to make you feel nervous and bad. Thus, people who are opposed to Social Security like the idea of attaching this term to it. People who are in favor of Social Security dislike attaching this term to it.

However, in neither case are people really discussing anything of substance. They are making minor points about whether or not their phrasing can win out and thus their affect can prevail in the minds of readers. This is intellectualism at its absolute worst.

 

Third, the importance of taking ridiculous, sarcastic, facetious and otherwise mocking statements serious. This is a long standing practice of mine for dealing with “class clowns.” There is often someone in lecture who gets a kick out of making snarky comments about what the professor is saying.

Rather than dismissing them, I think its best to treat as if they were a completely rational and well thought out position. Partially, this is because it draws the person into your frame. You can think of it as the opposite of “stooping to their level.”

And, also because it’s a good learning exercise. If something is asinine we would like to be able to say exactly why its asinine.

So here is a cartoon curtsey of the Mercatus Center

JWPW_9_4_11Ponzi.jpg

Now this is supposed to offend/embarrass proponents of Social Security. Its supposed to allow opponents an opportunity to snicker. However, lets take it seriously and look at the points its making.

I’ll just note a couple of important things about the two pictures first and then we can discuss.

  1. Payer in the Ponzi picture is rich, while the payer in the social security picture is poor
  2. The payer in the Ponzi picture is handing over his money voluntarily while the payer in the Social Security picture is doing so at gun point
  3. The person receiving the money in the Ponzi picture is a private citizen, were the person receiving it in the Social Security picture is the federal government

So, I think that point (1) is not particularly relevant to this analysis. Its relevant to the potentially regressive nature of the payroll tax but that is somewhat orthogonal to the point about “Ponzi schemes.”

What we really want to focus on are points (2) and (3). They are important.

First, point (2) is important because one has to ask why the investor is voluntarily handing over money. In the SS picture it is clear that he has no choice. He is being forced to.

However, in the (2) he is choosing to.

Why?

Well, in general because the Ponzi scheme architect has mislead him. He has caused him to believe that the money will be used to create enforceable claims on real resources. This claims will be worth more in the future than the cash is to today. Thus the Ponzi is a good investment.

Indeed, however there are no enforceable claims. Either there is outright deceit as in the case of Madoff and Stanford or there is trickery as in the case of chain letter. The Madoff case takes advantage of the principle of lying.

Lying works by telling someone something that is not true. If they believe you then you can get them to operate on the basis of a state of nature which is not in accordance with the actual state of nature.

Trickery works by taking advantage of someone innate confusion over the state of nature. The victim in this case does not understand the difference between a “hope” and a “legally enforceable claim” and you use that to sell hope as if it were legally enforceable claims.

This misdirection is the key problem with Ponzi like schemes. The problem is not that they are unsustainable and will come crashing down, as I will address later. Indeed, a Ponzi scheme need not crash. Indeed, legalized gambling is effectively an open Ponzi scheme structured so that it will never crash.

Point (3) is that in the Ponzi picture the person taking the money is a private citizen where in Social Security it is the Federal government.

This is also important because the private citizen is bound by the laws of the Federal Government but the Federal Government is bound only by popular sovereignty.

So, inherent in a transaction between private citizens is that the government represents a force able to coerce the terms of this transaction. If the recevier of the money skips town for example, the government will endeavor to find and imprison him.

This means that as long as the two private parties are honest about the terms of their agreement there is a good chance the agreement will hold.

This state of affairs does not exist between a private citizen and the federal government. The federal government can at any time refuse to honor the agreement and ultimately the citizen has no recourse. This is more complicated in the case of formal contracts and division of powers but the basic issues that no one can coerce the institution with a monopoly of coercion stands.

In particular because social security has no contract and exists only at the whim of the legislature, there is no protection whatsoever from popular opinion moving away from honoring the claim.

Thus while the private taker of cash cannot easily announce that he has changed his mind and the giver will receive a “return cut” the government could in theory simply change its mind and say that the giver will receive a benefit cut.

Outside of the frame is also the issue I touched on earlier that the coercive power of the state means that it has no trouble making good on these claims.

 

Now one final quick word on expectations. So if you got to Vegas, for example, the money you hope to win only comes from money someone else has lost. This is what I think gives people the sense of “Ponzi scheme.” Nothing is being created. Only money is being shuffled around.

However, in Vegas they do not hide the fact that this arrangement yields a negative rate of return. Well if it yields a negative rate of return then it is sustainable, despite the fact that it is just shuffling money.

Now you might say okay but no one thinks that Vegas is an investment. Fine.

However, people do think that the stock market is an investment. Yet, they do not see that it is bound by the same constraints. Investment brokers will confidently and with pride point out how stocks returned over 10% per year since the Great Depression.

They do not realize – I believe – that they are obviously leading their clients to believe that unsustainable returns are possible. The economy is only growing at 3% a year. One cannot have a stock portfolio that perpetually returns 10% a year inside of an economy that only returns 3% per year.

That would imply that the share of the economy claimed by stocks is rising each year. First, this is empirically inaccurate but more fundamentally it’s a problem because one cannot have a sensible claim on more than 100% of the entire economy.

If your claim on economic product is growing faster than the economy this must eventually become the case.

This is why I say the deceit not the money shuffling is the key driver of unfortunate consequences.

We can tell people straight up that they will earn negative returns and then have great fun at a money shuffling party called the Bellagio Hotel and Casino.

Or, we can invest in real resources but lead people to believe these investment will yield unrealistic returns – as in the case of many 401(k)s – and then we are going to wind up with a lot of tears and broken dreams.

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