Wednesday, December 17, 2008

Our Cherished Ponzi Schemes

Many are upset by the $50 billion 38-year fraud perpetrated by erstwhile investment guru Bernard Madoff. Madoff appears to have run a massive Ponzi scheme that bilked high rolling investors that purposely sought risky unregulated instruments.

The way a Ponzi scheme works, the promoter uses principle funds from later investors to pay supposed gains to earlier investors. Unlike real investment returns, there is no actual increase in value. The promoter pays out enough faux gains to keep investors from withdrawing their funds and to generate enough interest to attract new investment.

These kinds of schemes are also frequently referred to as pyramid schemes because they require an ever expanding base of new participants and/or capital to provide funds needed to pay fake gains to existing participants. Such schemes ultimately fail because the point unavoidably arrives where the promoter is unable to attract sufficient new capital to pay off investors.

The truly amazing thing about Madoff’s scam is that he was able to keep it going for nearly four decades. Given this term, it is probable that he had some real assets beyond the investors’ seed cash, so it was likely not a pure Ponzi scheme.

Still, Madoff’s feat is so astounding that the WSJ’s Holman W. Jenkins, Jr. was moved to opine (tongue-in-cheek) that Madoff “should immediately be put in charge of the Social Security and Medicare trust funds,” our nation’s largest Ponzi schemes.

Both Social Security and Medicare rely on funding provided by future recipients to pay off current recipients. The perpetual plan is for new generations of workers to cover the costs for retirees and non-producers. And that might work just fine if we were continuously producing enough new workers to keep the worker-to-beneficiary ratio even. But we’re not.

People are living far longer than they used to live, meaning that Social Security and Medicare pay out far more lifetime benefits per recipient than in the past. Despite the baby boom, the U.S. birth rate has roughly steadily declined for the past century (with some ups and downs), dropping from 30.1 per thousand in 1910 to 14 in 2005. During this same period the death rate per thousand has dropped from 14.7 to 8.2.

To put it plainly, we are steadily producing fewer new workers to pay into Social Security and Medicare while simultaneously producing far more longer-term beneficiaries of these programs. The European experience of the past four decades firmly demonstrates that importing immigrant workers does not solve the problem.

Last week Bernard Madoff discovered that he could not forever forestall the collapse of his Ponzi scheme. Similarly, we cannot forever put off the coming collapse of our Social Security and Medicare Ponzi schemes. Even the government’s ability to print money — a luxury Madoff couldn’t apply — will eventually peter out.

The Boston Globe reports that Medicare Part A will become insolvent “somewhere between 2016 and 2018,” earlier than the previous estimate of 2019. The plan could be insolvent before Barack Obama wraps up his presidency. Even with the immanency of the problem, politicians are readying a plan that would basically expand Medicare to cover everyone in the U.S., presumably under the mindset shared by the likes of AIG and GM that making it bigger will somehow keep it from failing.

But we can all breathe a huge sigh of relief when it comes to Social Security. Its trust funds (really just IOUs from the government, as explained in this Heritage Foundation report) won’t be exhausted until about 2038 per this Social Security Administration document. We can still squeeze in a few more presidential administrations before that happens.

If you watch the business world (especially lately), you realize that when an entity becomes insolvent it does not necessarily cease operations. Many airlines have been technically insolvent for years. Many entities have gone through bankruptcy and emerged to become solvent and relatively reliable players. Reorganization bankruptcy allows an otherwise viable operation to restructure both finances and operations. Usually, only completely unviable entities shut down altogether.
As a side note, that’s why the Big-3 automakers’ insistence that bankruptcy would cause them to cease operations is ridiculous. They still produce nearly half of the cars Americans buy. They are still viable businesses outside of their encumbrances. Bankruptcy would allow them to restructure contracts, liabilities, assets, and operations to emerge productive and profitable. The union might not survive in its current form, but that’s a far different issue than automakers shutting down. The only reasons anyone is discussing a government bailout of these firms are the $75 million lobbying dollars the Big-3 have spent and the $150 million campaign contributions the UAW has spent this election cycle.
Likewise, Medicare and Social Security won’t stop making payments the moment they cross the line of insolvency. But eventually the point will be reached that a reordering of services and liabilities will become necessary for operation to continue. If we don’t take care of it sooner, insolvency may be that point. Or the politicians may apply superficial remedies that temporarily push the problem down the road a few years.

No matter what we do, as long as we insist on the Ponzi model for Social Security and Medicare, we are fighting a losing battle. All Ponzi schemes inescapably collapse. The ultimate collapse of Medicare and Social Security may come many years after initial insolvency is reached. But without significantly changing the underlying model, these programs will fail.

Perhaps this will not occur during my lifetime, but I wouldn’t be surprised if it did. At any rate, it’s pretty shoddy business to push an onerous problem we are capable of addressing off to some future generation.

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