Is Social Security A Ponzi Scheme?

I was listening to the podcast of NPR's "Planet Money" this week and on the episode about savings (3/30), economist Kent Smetters started talking about Social Security.

When you think about the fact that Social Security does not make any real "investments," but just collects money from workers (its "investors") and uses it to pay the investors who got in earlier... does that remind you of anything else recently in the news? (Clue: Madoff)

Can Social Security keep adding enough new investors (my sons) to continue paying returns to the earlier investors (me and my mom)? It seems pretty evident that at some point the Social Security scheme has to fail.

Now, a Ponzi scheme pays returns to investors from their own pool of money, or money paid by subsequent investors. There are no actual investments. It's pay—as—you—go.

Social Security paid very nice returns, especially to the earliest investors. Here's a nice little piece of SS trivia. Did you know that the first person to get a check from the new "national savings plan" was Ernest Ackerman? He was a streetcar motorman and he retired one day after the program went into effect. He had five cents deducted from his check for that one day he was a 'participant' in the program. He received a lump sum payment of 17 cents. That is a 240% return.

In 1939, a bunch of changes came to the program. People were thinking of this as a a "retirement system" (a dangerous concept that will eventually doom the system). The government moved up the start of monthly payments by two years.

According to Social Security Online, the first monthly Social Security check went out on January 31, 1940. The recipient was Ida May Fuller, a retired legal secretary from Vermont. Her check was for $22.54. After cost of living increases and 35 years of receipts until her death in 1975, she had received $22,888.92 in payments. She had contributed $24.75 to the system.

You figure out Ida May's return on investment. It makes Chuck & Bernie's schemes seem like a lousy investment.

By the way, I thought that this Social security as Ponzi scheme idea was an original thought of mine. Nope. Do a search. Lots of folks have been talking about this for a lot longer than the past few months.

Modern Financial Insanity

Is there any upside to the financial chaos of the stock markets? Maybe.

I was listening last month to an NPR interview with author Michael Lewis. Lewis wrote his 1989 best-seller Liar's Poker which did not paint a very positive portrait of Wall Streeers. Of course, in that book you were expected to gasp that an investment bank CEO might make $3 million a year. Now, we might see that as not so bad. Liar's poker is (or was) a game played in the down time by workers on Wall Street. The game objective? Reward trickery and deceit.

Lewis describes his four years on Wall Street from hiring to time as a successful bond trader.Things have changed. While Lewis illustrated how changing securities markets made bonds the best game on the Street, I can say from personal experience that bonds is not the safe place any more.

He released Panic: The Story of Modern Financial Insanity late in 2008 and I bought it for my finance-major son, Drew, for Christmas. Over the break, I read it too.

It is a collection of essays and articles written during the past two decades that opens with the crash of October 1987. I recall being hit in that crash that year that Drew was born. It took a hit on his newly created college fund.

If you had to pick a moment when those principles first appeared a bit shaky, you could do worse than the 1987 stock market crash...

Black Monday was the first of a breed: a crash that suggested disastrous economic and social consequences but in the end had no serious effects at all. The bursting of the Internet bubble, the Asian currency crisis, the Russian government bond default that triggered the failure of the hedge fund Long-Term Capital Management—all of these extreme events have been compressed into a fantastically short space of financial history. And all seemed, in the heat of the moment, to have the power to change the world as we know it. None of them, it turned out, was that big a deal for the U.S. economy or for ordinary citizens.

But the current crash from 2008 that will certainly carry through 2009 is a different crash.

The size of the problem is massive. Not only did trillions — trillions — of dollars get lent to people who won't be able to repay them, but Wall Street at the same time created a market in side bets about whether these people would be able to repay their loans. And that market in side bets is tens of trillions of dollars.

Lewis contends that all that money went to "building a lot of houses that we can't afford" and other "unproductive assets."

"The biggest sum of money ever made by a single person in the history of Wall Street was made last year by a hedge fund manager named John Paulson, who made almost $4 billion for himself because he took the other side of the bets. … Big money has been made, but by very few."

For my son, who was thinking about going into investment banking, the word is that the people taking big risks and earning big returns in the financial markets won't be working at places called banks.

They may be working at hedge funds or in private equity, but that will be a much smaller operation and, in general, the appetite for risk will be dramatically reduced. I don't think, going forward, you will see people working at a place called Goldman Sachs taking home $70 million or $80 million at the end of each year, which they have done in the past.

One of the madnesses of the last 25 years … has been the rewards we've bestowed on financiers. The people who have actually been allocating the capital on Wall Street have done a rather bad job of it.

Last fall, visiting his alma mater, Princeton University, Lewis was interested to find out "what the kids who were going to be investment bankers were now going to do with their lives."

Turns out he was "frustrated with how unimaginative young people had become in choosing their path in life." He suggested that they spend a week with a hedge fund manager "just to see how miserable" they'd be after 20 years.

His suggestion to graduates like my son "who thought they were going to be financiers are having to rethink the premise, and that's a very good thing."

Maybe I need to go back to the lesson of the Oakland A's that were the focus of Lewis's Moneyball. They had the problem of trying to win in the Major Leagues with a budget that was smaller than almost every other team.

Instead of following the conventional wisdom - big name hitters and young pitchers with hot arms - they went with lots of carefully interpreted statistical data to use hitters with high on-base percentage and pitchers who get lots of ground outs.

Rethink the markets.