Charles Ponzi and Social Security

 In January 2009, Larry DeWitt of the Social Security Administration Historian's Office wrote a "Research Note" called "Ponzi Schemes vs. Social Security."  DeWitt includes a nice short history of what Charles Ponzi actually did.

"Charles Ponzi was a Boston investor broker who in the early months of 1920 was momentarily famous as a purveyor of foreign postal coupons who promised fabulous rates of return for his investors. Ponzi issued bonds which offered 50% interest in 45 days, or a 100% profit if held for 90 days....

Ponzi opened his company, "The Securities Exchange Company," at 27 School Street in Boston the day after Christmas 1919. He was penniless at the time and had to borrow $200 from a furniture dealer in order to furnish his new office. Within days he was collecting money from his initial rounds of investors. He then expanded the circle of investors by collecting money from a larger round of investors. When the bonds of the first investors came due he paid them, with their miraculous profit, using the money collected from the second round of investors. The news of these extraordinary profits swept up and down the east coast and thousands of investors flocked to Ponzi's office for an opportunity to give him their money. Using the money from this new surge of investors he paid off the next round of bonds as they came due, with their full profit, which excited even more frenzy. ...

Ponzi started his scheme on December 26th. Precisely seven months later, on July 26th, at the insistence of the Massachusetts District Attorney, Ponzi quit accepting deposits from new investors. It was estimated that Ponzi had been taking in $200,000 a day of new investments prior to the halt. At that point he had already collected almost $10,000,000 from about 10,000 investors. As word got out about his legal troubles, worried investors swarmed his office. Ponzi confidently greeted them and assured them all was well. ...

From July 26th until he was jailed on August 13th, Ponzi kept up this practice, appearing at the office each day and redeeming bonds from worried investors. During this time he actually redeemed $5,000,000 of his bonds in a futile attempt to convince the authorities that he was on the up and up. At his bankruptcy trial, it was discovered that Ponzi still had bonds outstanding in the amount of $7,000,000 and total assets of about $2,000,000. Indeed, the seemingly lucky investors who redeemed their bonds after July 26th had to return their windfalls to the bankruptcy court to be distributed among Ponzi's larger circle of creditors. Ultimately, after about seven years of litigation, Ponzi's disillusioned investors got back 37 cents on the dollar of their principal, with, of course, no whiff of any profits from the nation's first and most notorious Ponzi scheme."

How does Ponzi's arrangement differ from the Social Security system? As DeWitt points out, the U.S. Social Security system is a transfer program between generations, from those in working age to those in retirement, not a pyramid scheme that relies on attracting continually increasing numbers of "investors" to pay off those who invested earlier. DeWitt writes: 

"If the demographics of the population were stable, then a pay-as-you-go [Social Security] system would not have demographically-driven financing ups and downs and no thoughtful person would be tempted to compare it to a Ponzi arrangement. However, since population demographics tend to rise and fall, the balance in pay-as-you-go systems tends to rise and fall as well. During periods when more new participants are entering the system than are receiving benefits there tends to be a surplus in funding (as in the early years of Social Security). During periods when beneficiaries are growing faster than new entrants (as will happen when the baby boomers retire), there tends to be a deficit. This vulnerability to demographic ups and downs is one of the problems with pay-as-you-go financing. But this problem has nothing to do with Ponzi schemes, or any other fraudulent form of financing, it is simply the nature of pay-as-you-go systems....The first modern social insurance program began in Germany in 1889 and has been in continuous operation for more than 100 years. The American Social Security system has been in continuous successful operation since 1935. Charles Ponzi's scheme lasted barely 200 days."

Thanks to David Henderson at EconLog for the pointer.