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.