Well, I don't actually mean to defend Ponzi schemes, it's just that I've heard the term used incorrectly one too many times. Bernie Madoff and Tom Petters put a lot of work into concocting their schemes, and I'm sure they don't appreciate it when people casually accuse the Social Security program or the Federal Reserve of being Ponzi Schemes.
Jim Cramer on his Mad Money show said, “We all know the name of the biggest Ponzi scheme in history and it’s not even illegal. In fact, it is run by the U.S. government. And the name of it – well, they call it Social Security.” John McCain similarly said in reference to Social Security, “It’s a Ponzi scheme that Bernie Madoff would be proud of.” Texas Governor Rick Perry (no relation to myself as far as I know) said that counties that opted out of Social Security are “going to take care of their people in the future. You can't say that for Social Security. It is indeed a Ponzi scheme.”
We should start by establishing just what a Ponzi scheme is. I was among the presumably few who were familiar with the term 'Ponzi scheme' before the Bernie Madoff collapse. A few years ago I dabbled briefly in Second Life, an online virtual world. Second Life has its own economy with a virtual currency that can be exchanged for real US dollars. Several virtual banks were launched by Second Life users, but unlike normal banks, these ones offered APYs of around 70%. The most prominent of these was Ginko Financial, which reportedly owed depositors $750,000 at the time it collapsed. Ginko's management never admitted guilt, saying that if a bank run had never occurred, it would have been able to pay all obligations. It's difficult to draw the line for what's too good to be true. SPM Structured Servicing Holdings returned 134.6% in 2009 by investing in mortgage-backed securities. I'm not making a direct comparison here, those returns are unsustainable, and investors were never guaranteed anything (not even that their initial investment would be preserved). In the end, the biggest red flag with Ginko Financial was that its management was never very clear in explaining how it was making so much money.
Charles Ponzi didn't invent the Ponzi scheme, but his operation, which took in millions of dollars in 1920, will remain one of the most legendary. Ponzi didn't plan on setting up an outright fraud starting out. He tried to start a legitimate business selling advertisement in a business listing catalog. This failed, but he received a letter from a Spanish company inquiring about the catalog. The letter contained an international reply coupon (IRC), basically a coupon that can be exchanged for postage in any Universal Postal Union member country. This gave Ponzi the idea for an arbitrage operation in which he would buy IRCs from countries where they are very inexpensive and then redeem them in the United States. He borrowed money and sent it to relatives in Italy who then bought IRCs and sent them back. It turned out that Ponzi had miscalculated the overhead expenses of buying and selling large amounts of IRCs, but peoples willingness to lend him money with the promise of a 50% return in 45 days was apparently enough to convince him to make the leap from the business of arbitrage to that of fraud. While he continued to claim that he was making money hand over fist using IRCs, any and all interest that he actually paid out was from money obtained from new investors. The scheme was ultimately doomed to failure, as the pool of potential investment money was limited. Ponzi, perhaps cognizant of this fact, bought a controlling share of Hanover Trust Bank of Boston and began plans to start a conglomerate involved in banking and import/export operations near the end of his scheme. It seems he thought that he could return to legitimate business if he could just sustain the fraud long enough.
The typically identified similarity between Social Security and Ponzi schemes is that payments to beneficiaries are financed by taxes on current workers, who also will, in theory, expect to get benefits when they retire. Firstly, this isn't exactly true, but more importantly, it wouldn't make it a Ponzi scheme even if it were true. When Michele Bachmann said “Social Security, like I told you, is out of money. This year it is borrowing from the general treasury,” she was just doing what Michele Bachmann does best: making stuff up. The Social Security Administration reported that by the end of 2010 assets in the retirement fund totaled about $2.4 trillion. That is the highest it's ever been. That isn't to say that there are no problems. The fund will eventually start to be depleted, but even without reforms, the fund is not expected to be out of money until sometime between 2037 and 2052.
The most important difference between Social Security and a Ponzi scheme is that Social Security never claimed to be producing fictitious profits. Moreover, too many people seem to think that their Social Security account is equivalent to a 401k or IRA account. Social Security is an insurance program. Although there is a relationship between one's account and the amount they receive in benefits, individuals do not own their Social Security accounts.
The logic of those who claim that Social Security is a Ponzi scheme could be used to claim that any organization with increasing liabilities is a Ponzi scheme. Just to give one of a multitude of examples, AMR Corporation, better known as American Airlines, had an increase in total liabilities of $817 million between 2008 and 2009. During that same period it had an operating loss of $1.004 billion, but American still has yet to default on any of its debt. By the logic of Cramer, McCain, and Rick Perry we should conclude that American is paying coupons on its bonds, not with money it has obtained through operations, but with money it acquired from new debt, and is therefore a Ponzi scheme.
The problems in the Social Security system could easily be fixed by increasing taxes, but at this point it seems there will be more political will in the Capitol to do the inverse: decrease benefits. In 1935, during this country's worst financial crisis, a decision was made to take care of the elderly, the disabled, and the surviving families of deceased workers. How is it possible, that with all the technological advances since then, that we now no longer have the ability to do this.
I don't think Ponzi or Madoff were really driven by greed. Near the end of his life, after being deported from the United States, Charles Ponzi gave a final interview while living in Brazil. "Even if they never got anything for it, it was cheap at that price. Without malice aforethought I had given them the best show that was ever staged in their territory since the landing of the Pilgrims!... It was easily worth fifteen million bucks to watch me put the thing over," he told the reporter. Prestige motivates more than greed. It motivates despots to massacre their opponents rather than retire comfortably. Many volumes could be written about how to achieve it, but under the ethos of capitalism achieving a dollar figure is sufficient. The question of how that figure was achieved is, inevitably, secondary.
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