Tuesday, August 11, 2015

Is Every Bank a Ponzi Scheme?

by Neil H. Buchanan

Each year, when the Social Security trustees issue their annual report, I have dutifully written columns and posts explaining why the possibility that the Social Security retirement trust fund might someday reach a zero balance -- the guesstimated date of which is really the only item in the annual report that receives any mention in the press or from politicians -- does not mean that the system will be "bankrupt," nor that post-Baby Boomers will be left with nothing, and on and on.

Last year, things were a bit different, with everyone all but ignoring the release of the trustees' annual report.  This caused me to wonder aloud (if a bit sardonically) in a post here on Dorf on Law, "Is the Attack on Social Security Finally Over?"  Of course, it is not, but the release of this year's annual report attracted so little attention that I thought I might actually skip a year.  It was not to be so, however, and my new Verdict column, "The Unending Task of Debunking Social Security Fear-Mongering," amounts to an almost accidental contribution to the annual "Is it going broke?" game.

In that column, I describe a short segment on a morning program on Fox News that I happened upon while channel-surfing in my hotel room at the SEALS conference.  That four-minute-or-so interview, between one of the interchangeable Fox hosts and one of Fox Business News's faux financial experts, was so rife with stupidity and sloppiness -- the least of which was that the participants had not even bothered to note the slight improvements included in this year's trustees' report --  that it provided an irresistible opportunity to summarize and debunk (again) some of the most persistent right-wing myths about Social Security.

Amazingly, it was necessary to devote the first section of the column to debunking the claim that Social Security is a Ponzi scheme.  The Fox Business News talking head actually called it a Ponzi scheme twice.  I really thought that Rick Perry's misadventures in Ponzi-land in 2011 and 2012 had ended this nonsense, but it keeps coming back.  PolitiFact correctly rated the claim as "False" after a Republican back-bencher repeated Perry's claim late last year, for example.  (I must say, however, that PolitiFact's reasoning was more than a bit beside the point: "A Ponzi scheme is by definition an illegal crime and an unsustainable set-up that crashes very quickly. Social Security and Medicare, which have been around for decades, are not criminal schemes.")

What is most interesting about the attacks on Social Security is that they overwhelmingly rely on misrepresentations of basic accounting.  In fact, as the title to this post suggests, if one believes the logic of those who call Social Security a Ponzi scheme, then one would have to believe that nearly all financial transactions are a Ponzi scheme, as I will explain momentarily.  As I described in a Dorf on Law post titled "Money is Magic" back in 2013, many people are easily confused by modern financial transactions -- so confused that they will support a return to the gold standard, or undermine a successful and popular retirement program.

The claim that Social Security is a Ponzi scheme begins (and, to be brutally honest about it, also ends) with the observation that workers' payroll taxes are not being "saved," but are instead being used to pay for current retirees' benefits.  Where, critics ask, is the money?  And why is the trust fund "being spent on current government programs"?  There is never anything "there," they say, no pile of money from which people will be able to draw their money in the future.  It is all gone, right?

Many scholars have noted that running Social Security as a pay-as-you-go system (which is the basic structure of the program) is identical as an aggregate accounting matter to setting up a system of private accounts.  (See, for example, this 2007 Cornell Law Review piece.)  Suppose that you have a "fully funded" system of private accounts.  At any given time, workers would be depositing money into their accounts, while retirees would be withdrawing money from their accounts.  In what is known as "steady-state equilibrium," the dollars going into retirement accounts would match the dollars being withdrawn.  If there were more withdrawals than deposits, the banks would have to do something to come up with the extra money, and if there were more deposits than withdrawals, the banks would have extra money to invest.  The larger point, however, is that a well-functioning system could be set up as pay-as-you-go or as a system of private accounts, and the overall accounting and flow of funds would be the same.  (Once a country has a pay-as-you-go system, however, transitioning to a system of private accounts would penalize current workers.  But that issue is beyond the scope of this post.)

More to the immediate point, what would happen to the money that would be deposited in those hypothetical private retirement accounts?  Or, for that matter, what is currently happening to the money that people are putting into real-world 401(k)/403(b) accounts?  We know for sure that banks are not sitting on the money.  In fact, those deposits are being used by banks not only to cover withdrawals, but to the extent that there are more deposits than withdrawals, the banks are putting a whole lot of money into -- Wait for it! -- U.S. Treasury bonds.  When the Baby Boomers start to draw down our private savings accounts to pay for medications, yoga classes, prune juice, and hair dyes, the banks will have to cash in those Treasury bonds and find other sources of funds, or the banks will become insolvent.

That means that the banks are just as dependent on the federal Treasury for financing people's retirements as Social Security is.  And I really mean "just as dependent," because banks are going to rely on deposits from new or existing account holders for the funds to cover retirees withdrawals, and then they will have to come up with extra funds if the deposits are insufficient.  Banks are holding huge portfolios of Treasury bonds on their balance sheets, and they will be able to use those bonds as the equivalent of cash, but only if the Treasury honors those obligations.

Indeed, this surface equivalence that makes people scream "Ponzi!" is not even limited to banks that handle accounts for retirees.  The classic scene in "It's a Wonderful Life," where the townspeople ask Jimmy Stewart where their money is, is still the best way to think about the fundamentals of how banks work.  He explains that their money has been loaned to other people in town, and even though the money is not in the vault, it is still a legally viable claim -- but only if people do not panic and cause the whole thing to collapse.  Banks accept deposits, loan out almost all of that money, make a profit on the interest rate spread, and cover each day's withdrawals from the small amount of vault cash (or the e-equivalent) when the day's deposits fall short.

Because banks can experience "runs," where panic-stricken depositors demand cash that those depositors would otherwise have had no desire to withdraw, they are fragile in a way that Social Security could never be.  Social Security has a payment schedule that is well known in advance, and that cannot be accelerated by individual action.  (When some people choose to retire early, the net result is actually to improve Social Security's long-run viability, because of the size of the the hit to benefits due to early retirement.)

In my column, I quote a Securities and Exchange Commission fact sheet, answering the question: "Why do Ponzi schemes collapse?"  Their answer: "With little or no legitimate earnings, Ponzi schemes require a consistent flow of money from new investors to continue. Ponzi schemes tend to collapse when it becomes difficult to recruit new investors or when a large number of investors ask to cash out."  In banking, even though the earnings are legitimate (that is, the borrowers are paying interest to the bank, in excess of the interest being paid to depositors), the "scheme" can still fail, simply because large numbers of investors can ask to cash out.  That is what the banking side of the Great Depression was all about, and it is the towering success of the 2008-09 intervention by the Federal Reserve and other government agencies that we did not face a much worse fate this time.

In some ways, of course, this is an unfair argument.  Clowns like Rick Perry do not care what any of this means.  And even supposed financial experts on Fox do not care that they are speaking nonsense.  Even so, their alternative to a government-led pay-as-you-go scheme is a private pay-as-you-go scheme that is ultimately only as safe as the federal government makes it.  Now that's irony.


Hashim said...

Neil, if it turned out in twenty years that SS pay-as-you-go was coming up short and there weren't enough funds to pay retirees, what *legally* would the Social Security Administrator have to do to fund the shortfall? Specifically, would *Treasury be statutorily required* to pay for the shortfall (through existing cash or new debt), or would *Congress be required to appropriate new funds first*. Because if it's the latter, then it seems to me that there's a pretty significant difference between Social Security and private accounts in a bank w/r/t dependence on the federal treasury -- namely, if the bank is short, it cashes in Treasury bonds that *must be repaid under the 14A*; whereas if SS is short, Congress can just tell retirees tough luck, because it presumably won't share your expansive understanding of the scope of debt under the 14A.

Greg said...

When people call Social Security a "Ponzi Scheme," lets just say they disagree with you less on the facts and more on the meaning behind those facts. On this particular semantic point, I wholeheartedly agree with you that "pay-as-you-go" does not equal "Ponzi."

It seems to me that one problem with Social Security being funded exclusively through US treasuries is that it artificially reduces the interest rate of US treasuries. Since the Social Security Administration has no choice but to buy treasuries, they are willing to buy them at a rate of return below what would be available for some other forms of investment. Thus, the government gets to finance roads and aircraft carriers and pencils at a reduced interest rate because they have a captive market for those loans in the social security trust fund.

If the SSA was allowed to invest the trust fund in a more broad range of securities, they would presumably get (at least marginally) a higher rate of return, and the government would have to pay a marginally higher interest rate on US treasuries. There would be some external organizations making money on the inefficiency in the system, but the key point is that the trust fund would get a better return, at the expense of higher interest rates for the federal government.

In a sense, as the trust fund money is slowly withdrawn, we will return to a more equilibrium rate of return for US treasuries, but in the interim the US government will have benefited from a reduced interest rate, at the expense of the people in the form of the social security trust fund.

Put another way: Market restrictions are rarely to the benefit of the one being restricted, and the SSA is restricted in how to invest the trust fund.

BTW, I'm not even necessarily saying that a market-based investment of the trust fund is better, I'm just saying that the efficiencies that are gained by forcing the trust fund to invest in US treasuries are overwhelmingly to the benefit of the current government and not the trust fund itself.

Hash - If you are referring to withdrawing from rather than depositing in the trust fund, I don't think Congress would have to do anything. If you're talking about a scenario where the trust fund has been exhausted, then yes, Congress would likely have to be involved in any solution.

t jones said...

Or, Congress can increase contributions from the then employed (e.g., raise the cap on income subject to the "tax" or raise the rate). Reducing benefits or appropriating from the general fund are not the only alternatives.

Hashim said...

Neil, as I suspected, the Congressional Research Service report linked below confirms that, if the Social Security Trust Fund runs out, it would violate the Anti-Deficiency Act for the SSA to pay the shortfall absent Congressional appropriation. So isn't that a pretty serious difference between SS pay-as-you-go and private accounts, at least until the Govt hits the debt-ceiling (and, at least arguably, even after that, insofar as the debt-ceiling violates the 14A but the Anti-Deficiency Act does not).


Hashim said...

(Also, the debt-ceiling might not even be an issue at all, since it's not clear why the debt ceiling would be a problem in a situation where banks are cashing in treasuries to deal with a bank run.)

Talkin' 'bout stuff said...

As an Australian reader of your column, I suggest that some of your comment might benefit from review. First, while it is true that a proportion of each worker's salary is placed into a fund, there is a choice of funds, some of which charge higher fees than others without any apparent higher benefit. So there is not a 'single national fund' so much as a 'single national program'. Moreover, this program allows a worker to choose his investment strategy (high growth, cash and bonds and so on) and leaves his wealth at retirement as an outcome of the decisions he makes about investment options. In other words, the risk lies with the individual. Second, there is no guaranteed pension for Australian residents other than for those who have less than a determined level of wealth (not including the family home). So for many, including me, the only income I have is what I am able to make from my own wealth, and with low % income over the past few years (2 - 3%) a couple needs about $2M in invested capital to have an income of about $60k to $70k/year. Virtually no-one has this level of capital. Finally, this scheme does not take account of longevity 'risk' - that is one outliving one's pension balance. All in all, I'd prefer to put my pension fund into a collective account and have a determined and guaranteed payment. The Australian arrangement may be artful, but it is also uncertain and may be contributing to a very conservation investment profile within Australia that is fettering industrial innovation and economic activity and development.