Social Security is a Ponzi Scheme?

Monday night’s Tea Party debate featured discussion about Social Security as a Ponzi scheme. Over the past several days this conversation has garnered an increasing amount of blog space. Given the extensive attention currently being paid to this topic and potential that it continues through next year's election, I decided to offer my own thoughts.

Before outlining my view, I think it’s important to clarify the criteria being considered to determine a Ponzi scheme. The following is directly from the SEC’s website:

“A Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors. Ponzi scheme organizers often solicit new investors by promising to invest funds in opportunities claimed to generate high returns with little or no risk. In many Ponzi schemes, the fraudsters focus on attracting new money to make promised payments to earlier-stage investors and to use for personal expenses, instead of engaging in any legitimate investment activity.”

While I believe this definition should be used as the basis for discussion, recent commentary suggests various other definitions are being considered. If that is the case, I’d urge politicians and others offering opinions to clarify their definition. Without knowing the basis for comparison, it is difficult to judge the merit of their views. However, since alternative definitions have not been provided, the one noted above will serve as the standard for my argument.


Although I disagree with the opinion that Social Security is a Ponzi scheme, acknowledging why some may make that argument will aid in debunking the theory. The basic design of Social Security provides benefit payments to older, retired individuals that are largely funded from payroll tax revenues paid by younger, income earning individuals. When the baby-boom generation entered the work force, yearly payroll tax revenues greatly exceeded Social Security benefit expenses and a trust fund was created to “hold” the surplus funds while accruing interest. Now, as the baby-boom generation retires and starts collecting benefits, payments have begun exceeding revenues. Based on demographics, these yearly deficits will continue to widen, ultimately exhausting the trust fund. Since payroll taxes will no longer cover all benefit payments, the expectation is that Social Security cannot fulfill its current promises. Whether or not one deems this outcome to be fraud, I believe this scenario leads many to believe Social Security is a Ponzi scheme.


Having established a basic premise for calling Social Security a Ponzi scheme, the deficiencies of that argument can be set forth. In the above scenario, an assumption is made that when the trust fund is exhausted, Social Security will be unable to pay promised benefits in full. A critical error within this assumption is the apparent view that Social Security is a stand alone program, not incorporated within the federal government’s budget. To some this may seem an inconsequential difference, however this small fact is crucial to determining the eventual solvency of the program.


The US government is a currency issuer, which means that under the current monetary system, the government can never run out of dollars. Ponzi schemes ultimately fail when a sufficient amount of new funds can not be obtained to repay all investment "returns" and withdrawals. With Social Security, when payroll taxes are no longer sufficient to provide the entirety of earned benefits, the government is required to supply the difference. Since the government never has to borrow funds in order to spend, regardless of tax revenue, Social Security benefits can always be paid in full.


As long as the US government remains a currency issuer, claims that Social Security is a Ponzi scheme are as foolish as comparing the solvency of the US government to either Greece or households. Apart from self-imposed constraints, the US federal government can always repay debt denominated in dollars, including future Social Security benefits. The one crux of this argument is that excessive money printing (deficit spending) can create inflation during periods of near full-employment. Stemming from this issue, the true question regarding Social Security and all government expenditures is whether tax levels are appropriate for the chosen size of government.


Social Security benefits can be provided indefinitely and therefore suggestions that the system is a Ponzi scheme are misunderstandings, at best, or at worst, intentional misrepresentations. Too much recent time and effort has been directed at worrying about deficits, both current and future. Our nation would be better served to focus on current problems of excessive private debt and longer-term concerns about the desired size of government. Hopefully our leaders will direct their attention and the nation’s to these problems in the days ahead.

Europe Bests US in Stock Opportunities

Following the global recession a couple years ago, I thought discussion about different sections of the global economy decoupling from one another would have ceased. Surprisingly, as Europe seemingly begins another economic downturn (several countries are already in a recession or depression), many investors and analysts remain of the opinion that Europe's problems will be largely contained. Will Europe's economic troubles be contained in the same manner as the US housing bubble (which was decidedly not)?

A post today on Pragmatic Capitalism, by Surly Trader titled UNITED STATES VERSUS EUROPE, highlights the divergence between the Eurostoxx 50 and S&P 500. The graph below compares the performance of these two stock indexes since the March 2009 lows. As you'll notice, the indexes initially moved significantly higher together, with Europe even outperforming to a small degree. Correlation remained pretty tight throughout the first portion of the sovereign debt crisis until May of this year. Since then, the S&P 500 is down nearly 15%, but the Eurostoxx 50 has lost more than 40%. Although a significant portion of the difference may stem from European banks (which currently face much larger funding issues), numerous other companies have been dragged down with the broader index.

Anyone reading or watching financial news over the past several weeks has surely heard a vast number of individuals argue that US stocks are extremely cheap based on forward looking earnings estimates. Ignoring for a moment that these estimates are almost always too optimistic, if one believes US stocks are cheap based on those metrics, than Europe is screaming "buy." As the article notes,

"The Eurozone is facing massive political headwinds, but at a dividend yield of 5.98% and P/E of 8.35, it looks relatively attractive versus the S&P 500′s 2.23% dividend yield and 12.71 P/E."

Based on these stock indexes, it certainly seems that Europe is pricing in a far worse economic outlook than the US. Holding the belief that if Europe experiences a significant economic downturn, the US will also be dragged into recession, European stocks, broadly, appear to offer a better risk/return profile.

Recent strength in US markets seems partially related to hope that the EU crisis will be kicked further down the road and that some version of QE3 will be announced next week. I've previously stated why the latter will be ineffective, apart from a short-term boost to stocks, and believe time is running out on the former. My personal view is to remain defensive, focusing on companies with strong balance sheets and large dividend yields. Two names within the Eurostoxx 50 that seem particularly enticing (and I currently own) are Sanofi (SNY) and Total (Tot). Both stocks trade at or below book value, sport P/E's below 7 and offer dividend yields above 5%. Maintaining a 3-5 year investment horizon, I believe these companies will offer significant relative value.

Inflation is NOT the Answer

A couple weeks ago I argued against the numerous economists calling for the Fed to establish higher inflation targets as a remedy for excessive debt. My concerns were centered around the notion that inflation does not create wealth, but rather transfers it from creditors to debtors. Since that post, several FOMC members, including Chairman Bernanke, have spoken about the current state of the economy and potential stimulative actions the Fed could take at its next meeting. Much of the commentary has been typical Fed speak, which involves saying very little in a manner that is difficult to decipher. However, parsing through words and actions has led a majority to expect some form of new quantitative easing to be announced on September 21st.

Recently, on Project Syndicate, Raghuram Rajan (finance professor at the Univ. of Chicago) penned an article titled, Is Inflation the Answer?. Rajan is effectively arguing against the same calls for much higher, short-term, inflation. Although the piece makes a brief note about the distribution effects of such a policy, the focus is on the effectiveness of creating higher inflation.

One critical factor that could hinder effectiveness is the Fed’s credibility. Having maintained a specific target for a long time, the unintended consequences of suddenly changing policy are unknown. If the target can be changed once, why not again, and again? A moving inflation target would also be difficult to explain within the realm of price stability. Were the Fed to raise the target temporarily, given its prior track record, why should the market expect inflation to remain under control? Within this realm of possibility, its fairly easy to foresee an outcome where inflation rises well beyond new targets and ultimately needs to be reigned in Volcker-style. For anyone who lived through that experience, recollections of the early 1980’s recession and double-digit unemployment are probably not pleasant.  

The other significant deterrent Rajan notes relates to the maturity length of current debt. A policy of high inflation is primarily beneficial if nominal income growth outpaces interest on debt. However, if debt needs to be rolled over in the near future (due to maturity), the new debt will require much higher interest rate payments. In that scenario, higher inflation’s impact on reducing debt burdens is minimal. As Rajan notes, this largely reduces the positive influence on government debt, bank liabilities and households with floating rate mortgages.

While I agree with nearly all of Rajan’s points in this article, one point I must argue against is the notion that “[foreign] investors might be needed to finance future deficits.” As I’ve shown numerous times before through MMT, the US government never needs to finance deficits. Aside from that opposition, I think Rajan makes a wonderful case against higher inflation. In conclusion, he adds suggestions for outright debt relief through write-downs. I remain convinced that this method of reducing debt burdens should be the primary focus of current federal policy.

Equity Analysts' Forgotten Word: Sell

Each day, various Wall Street equity analysts update stock recommendations and issue new opinions on previously uncovered securities. Depending on the mood of the market and prestige of the analyst, these recommendations can move a stock by several percent in a day. Numerous investors and money managers pay significant sums for these opinions, which subsequently aid in determining whether to buy, sell or hold specific stocks. Considering the amount of money spent on employing these analysts and the profit derived from their reports, one is persuaded to assume significant predictive value lies within Wall Street's research. Is this a fair assumption, or is Wall Street selling snake oil?

Well, according to recent data "published by Sam Stovall, the chief investment strategist of Standard & Poor’s Equity Research," the answer is almost certainly the latter. An article on MarketWatch yesterday by Robert Powell titled, Things are bad, but analysts can’t say ‘sell’, highlights Stovall's analysis. The numbers speak for themselves:

“Consider, at a place and time such as this, with the economy teetering on the verge of another recession, none of the 1,485 stocks that make up the S&P 1,500 has a consensus “Sell” rating. And just five, or 0.3%, are ranked as being a “Weak Hold.””

"There were (don’t laugh) just 167 (0.08%) “Sell” recommendations and 697 (4.2%) “Weak Hold” recommendations out of a total of the 19,868 Wall Street research reports reviewed in Stovall’s analysis."

Although Stovall's research screams of bias, he attempts to conceive of valid reasons the numbers are so skewed. One explanation offered is that “if stocks for the long run are on an upward trajectory, then everything is a hold.” At first glance this statement appears plausible enough to gloss over, but upon further examination it is extremely flawed.

When people discuss stocks having risen throughout history, they are generally referring to an index such as the S&P 500 or Dow. An important factor often overlooked in this comment is that those indexes are weighted based on market capitalization and price, respectively. This means that stocks which perform better over long periods exert far greater influence on the direction of the entire index than stocks that perform poorly. It should also be remembered that the worst stocks are frequently swapped out of these indexes for stronger ones, creating a survivor bias. Consider these stocks from 1980:

Allied Chemical, American Can, American Tobacco B, Bethlehem Steel, General Foods, Inco, International Harvester, Johns-Manville, Minnesota Mining & Manufacturing, Standard Oil, Texaco, Union Carbide, Westinghouse Electric, and Woolworth.

Those companies were all included in the Dow at the start of the 1980’s, yet many of the names are likely foreign to investors today because the stocks (and companies) no longer exist. The point that Stovall’s reasoning misses is one of basic capitalism. In the long run, most companies fail as new technologies and forms of production eliminate economic profits. The only way to avoid this outcome is through monopolies, either natural or government created. So unless analysts believe capitalism no longer exists in the US, it makes little sense to assume all stocks are at least a hold.

In our everyday lives, if a friend always gave the same advice, most of us would likely stop seeking advice from that friend. Regardless of the economic or market outlook, Wall Street recommendations consistently and uniformly provide the same guidance. Despite this knowledge, markets and investors continue to hand over money for Wall Street’s opinions. Stovall’s analysis is a helpful step towards unveiling the truth about Wall Street recommendations. Hopefully further research will expose the currently subjective process and ensure that stock recommendations are more objective in the future.

Inflationary Outlook Resembles Depression Era

Yesterday I remarked that current economic troubles are reminiscent of the depression era that Keynes and Hayek lived through. At that time, Keynes believed that deflation would continue indefinitely and sought actions that might prevent a deflationary spiral. Despite Keynes' brilliance, there were many factors influencing the post-World War II global economy that he failed to foresee. An influx of cheap natural resources from abroad, expanding global trade, the baby boom generation and government deficits all helped reverse the deflationary trend and create nearly constant inflation in the US ever since.

Although the US appears on the verge of recession, Americans are more concerned with hyperinflation than outright deflation. Randall Wray, an economics professor at the University of Missouri-Kansas City (and fellow Wash U alum), explains why The prospects for inflation have not been smaller since 1930. Wray is one of the top economists today promoting Modern Monetary Theory (MMT), hence his views on inflation versus deflation deserve significant attention. As Wray points out (and I have detailed previously), a primary reason Americans fear inflation relates to a misunderstanding of recent monetary policy conducted by the Federal Reserve. One cannot accurately assess the impact of quantitative easing without understanding how bank reserves function in a modern monetary system. The linked piece offers a wonderful, yet simple explanation for the casual reader.

Ultimately, inflation or deflation is about the quantity of money chasing a certain number of goods. As Wray notes, significant unemployment, declining real income and large household debt imply the direct opposite of hyper, or even high, inflation. If Wray's outlook proves true, investors currently rushing into gold and other commodities will find themselves on the wrong end of the trade. For most individuals, this prognosis should not be taken as negatively as typical news commentary would have one believe. Over the past decade, Japan's real GDP growth averaged .8% per year, despite averaging .3% deflation. During the same period, U.S. real GDP growth averaged only 1.6%, with average inflation of 1.9%. Many other factors certainly impacted economic growth, however a majority likely favor the US, rendering the minor disparity even less noteworthy.

I urge those readers concerned about inflation or considering investing in gold to read through Wray's entire piece for a different perspective. Given the struggles presently facing the global economy, hyperinflation should be the least of our concerns. Once we stop fighting the problems we don't have, policy making can return to focusing on the problems we do.



Interesting note: During the decade discussed above spanning 2001 to 2010, the Fed almost perfectly achieved its long-run inflation target of 2% (based on core PCE inflation). Even though the Fed was successful, real GDP growth over that span was the weakest experienced since the depression. The period mentioned also witnessed violent swings in prices. One personal suggestion for the future, is that our society rethinks the goals of the Federal Reserve and monetary policy.