Another government scheme that needs fixing.

• Author: Tanner, Michael
• Position: Social security - National Affairs

IN HIS BOOK, Fed Up, Texas Gov. Rick Perry claims that Social Security is "set up like an illegal Ponzi scheme." He explicitly compares Social Security's financing to the type of serious shenanigans "that sent Bernie Madoff to prison," explaining that "deceptive accounting has hoodwinked the American people into thinking that Social Security is a retirement system and financially sound when clearly it is not."

Perry's statements roundly have been denounced by other Republican candidates, especially former Massachusetts Gov. Mitt Romney, as well as many Social Security advocates and portions of the media.

It is not as though Perry is the first to observe that Social Security has many of the characteristics of a Ponzi scheme. For instance, economist Milton Friedman called Social Security "the biggest Ponzi scheme on Earth." So did his fellow Nobel laureate Paul Samuelson, who famously referred to Social Security as "a Ponzi scheme that works." Even some of the program's most ardent defenders have used the term. For example, Paul Krugman, a Nobel prize-winning economist--and columnist with The New York Times wrote of Social Security's "Ponzi game aspect, in which each generation takes more out than it put in."

Consider how a Ponzi scheme works. The operator recruits "investors," promising high returns on their investment or contribution, but the operator does not actually invest the money, and instead pockets it for himself. Because no investments are made, the scheme's operator only can pay returns in one of two ways: return a portion of the investment as "interest" or "profit" while convincing the investor to keep his principle invested, or recruiting new investors and using their money to pay the earlier ones. However, these new investors now will have to be paid, requiring the operator to recruit a third round of investors large enough to pay for both the initial and secondary investors. This continues until the operator no longer is able to recruit sufficient new investors and the system ultimately collapses.

Ponzi's scheme was not the first such swindle, but it was the classic model that has come to define such plans, as well as their near identical cousins, pyramid schemes and chain letters.

In December 1919, Carlo "Charles" Ponzi approached a group of friends and acquaintances in Boston with a new investment opportunity. Ponzi claimed that he had found a way to make money by exploiting postal rates among countries, using postage coupons to purchase stamps. At the time, postal systems worldwide offered coupons that could be utilized to buy stamps for replying to a letter, roughly the equivalent of a postage prepaid envelope. While the coupons were supposed to have a fixed value regardless of their country of origin, the post-World War I devaluation of many European currencies created an arbitrage opportunity. Ponzi proposed buying coupons on the cheap in countries such as Spain and then using them to purchase postage in countries like the U.S., where they were worth more. It might be considered similar to playing international currency markets today.

Ponzi's secret was that he was not actually buying postal coupons with the money or making any other investments. Instead, he simply was using the investments of later investors to pay returns to the earliest investors. At the height of his plan's popularity, with thousands of potential investors lined up to give him money, this was relatively easy to do. More than 20,000 people invested with him, at one point contributing as much as $200,000...