I think it’s fair to describe our current times as “interesting,” and there is a related story this week that is worth reflecting upon.  Chinese Premier Wen Jiabao delivered the keynote speech at an annual meeting of the World Economic Forum and he addressed a number of questions in a subsequent press conference.  Wen  suggested that China may be willing to lend a hand (or, more specifically, lend billions of euros) in order to help the troubled European economies that continue to work toward lasting resolution of their financial problems.

 Bloomberg reported on Wen’s statements, quoting him as follows:

“We have on many occasions expressed our readiness to extend a helping hand, and our readiness to increase our investment in Europe,” Wen said. At the same time, “they [European Nations] should recognize China’s full market economy status” before the 2016 deadline set by the World Trade Organization. “To show one’s sincerity on this issue a few years ahead of that time is the way a friend treats another friend,” he said.

First of all, there would be significant benefits for China if it were classified as a “market economy” rather than a “non-market economy” as it is presently considered.  Under the rules of the World Trade Organization, recognizing China as a market economy would make it very difficult for Europe to impose tariffs and trade restrictions on cheap Chinese products.

Here is why I believe this situation is so interesting: despite having one of the largest and fastest growing economies, China is still one of the poorest nations on earth.  As you can see from the table that follows, China ranks 93^rd in the world in terms of GDP per capita and actually ranks below Namibia and Angola (but slightly higher than Turkmenistan and Guatemala, which are not shown in the table).  As a result of having such a low GDP per capital, China obviously ranks very low in terms of income per capita and consequently the average Chinese citizen has a very low standard of living.  Nonetheless, China now finds itself in a unique position of leverage with the financially-hobbled European countries.

Note the European countries (blue shading) that are at the heart of the current debt crisis: Portugal, Italy, Ireland, Greece, and Spain.  On average, these five countries have a GDP per capita that is 7 times greater than that of China!  I think it’s safe to say that we do indeed live in “interesting times” when we face a situation in which one of the poorest countries on earth is among the only nations with sufficient savings and currency reserves to assist some of the wealthiest nations.

As you probably know, China is already the largest foreign creditor to the United States, holding more U.S. treasury securities than any other nation.  Now, despite having one of the lowest standards of living on earth, China is a nation that could soon play a constructive role in the European debt crises, presumably by buying tens of billions worth of euro-denominated sovereign bonds.

As Henry Kissinger wrote in his recent book, On China:

“China’s [diplomatic] strategy generally exhibits three characteristics: meticulous analysis of long-term trends, careful study of tactical options, and detached exploration of operational decisions.”

We are witnessing this diplomatic strategy in action.  China is gradually ascending to a prominent role on the global stage as she evaluates various tactical options and makes the operational decisions to gain economic leverage and political influence.  Despite being one of the poorest countries on earth, China may be the only country, outside of the European Union, that has the willingness and ability to help the Europeans resolve their own financial problems.  Of course, there is one small string attached to Wen’s offer of assistance, but friends don’t need trade restrictions against friends, do they?  Interesting times indeed.

For a minute or two I quickly scanned traditional news sources looking for information about the fire.  I visited the webpage for our local newspaper and saw “breaking news” about a road in downtown Austin that was closed, apparently due to some traffic incident.  Next, I tuned-in to a local TV station that was running a news show at the time.  I learned about an upcoming triathlon in the area and where I could park my car, but absolutely nothing was mentioned about the fire.  My wife and I then checked our Facebook pages and discovered through posts of friends the actual location of the fire (about 2 miles away) and promptly decided to evacuate.  There was a lot of information about the fire onTwitter as well.  Within the next 15 minutes our community, called Steiner Ranch, began to lose power and some residents had received reverse – 911 calls informing them of a mandatory evacuation order.  We quickly grabbed a few things, got the kids and cat in the car, warned a neighbor, and proceeded to leave.  By the time we reached the main road to evacuate our neighborhood there was a line of hundreds of cars trying to evacuate.  We could see heavy smoke and there were helicopters dropping water on the fire.

As we drove we continued to receive information about the fire through Facebook and Twitter.  We later learned where our friends had gone to stay for the night.  We saw photos that people had taken and posted online and learned of other resources for additional information.  Meanwhile, on one local news station, we saw a story about good recipes to cook for your Labor Day festivities.   I relay this story for one primary reason: this is the first direct experience that I have had with a fairly widespread emergency since the large-scale adoption of social media platforms such as Facebook and Twitter.  It was truly interesting to experience, first hand, the powerful nature of rapid information flow through social networks vis-a-vis the comparatively poor information provided through traditional media sources.

As seem in the image above, traditional media sources such as TV, radio and newspaper are similar to the depiction of a weak network.  One node, representing the source in the network, has a single connection to the other nodes in the network, but there are no other links between the nodes.  Furthermore, in actual practice, the traditional media model only allows information to flow in one direction, making it even worse than would appear to be the case from this network diagram.

By contrast, the strong network diagram more accurately depicts the manner in which Facebook works – each node in a network is fully connected to all other nodes, with information flowing in both directions through the links.  As you can discern, the true value of any network is largely a function of two things: the number of nodes in the network and the number of links that connect those nodes.   A local TV station, or newspaper, is nothing more than one node in the network.  And, in a situation such as the recent wildfire that forced my family and I to evacuate our home, the TV station was effectively a useless node, adding little value in the first hours of the emergency.  The most important nodes were our friends, who happened to live even closer to the fire and were able to rapidly disseminate information (using smartphones) to all of the other nodes.  It may be fair to question the accuracy of some of the information that we received, but it is often the case that timely, if somewhat inaccurate information is much more important than perfect, but delayed information.

During the next two days we largely relied upon Facebook and Twitter for the majority of the information that we received and shared with others.  I chuckled when I saw that the local news stations were using Facebook and Twitter as well, asking local residents to share their pictures and videos of the fire.  Rather than being the most important node in a weak network, the traditional media sources were marginalized and reduced to being a relatively unimportant node in a strong network.  I have to confess that I don’t use social media to the degree that many others do, but I recognize the awesome power and value that comes from a strong network with large numbers of links and nodes.  Facebook and Twitter are two of the most powerful networks that exist today.

To wrap up the story, we were allowed to return to our home on Tuesday morning, two days after the initial evacuation.  At its closest point, the fire was about two miles from our house.  On that morning, my wife and I had taken our kids for some play time outside – we had been staying at our in-laws house during the evacuation period.  When news broke that we could return home, I’m sure the local news sources, TV, radio, and so forth reported it immediately, but it didn’t really matter.  I was outside at a park, playing with my kids.  I learned about the lifting of the evacuation order immediately, through my smart phone, as the information was disseminated on Twitter.

First for a definition: the U.S. Securities and Exchange Commission states that “a Ponzi scheme is an investment fraud that involves the payment of purported returns to existing investors from funds contributed by new investors.”  Although none of us actually “invest” in Social Security, the SEC’s description of a Ponzi scheme is quite similar to the mechanics of how the Social Security system functions: the government collects contributions (i.e. payroll taxes) from current workers and then distributes that money to retired workers in the form of benefit checks.

But wait, you say, I have been paying into the system during my working years, so when I retire I will get my own money back (plus interest) and therefore Social Security is not a Ponzi scheme, right?  Actually, no, and here’s why: the money that current workers are paying into Social Security is not held in segregated accounts just for them – it is being paid out to current beneficiaries.  Someday when you retire, your contributions will be long gone – having already been distributed to those who retired long before you did.  When you retire, your social security benefit checks will be funded by those who continue to work and contribute payroll taxes during your retirement years.  In short, Social Security functions by making payments to existing retirees from money that is contributed by current workers, which is more or less the essence of a conventional Ponzi scheme.

To get a better idea of how this works, let’s start at the beginning of Social Security itself.  In January, 1940, the Social Security Administration issued its first-ever monthly benefit check, bearing check number #00-000-001, in the amount of $22.54.  The check was paid to a 64-year old woman in Vermont named Ida May Fuller (shown in the picture).  However, because the U.S. Social Security Administration had been created only a few years earlier, Ms. Fuller only contributed payroll taxes during the last 3 years of her working career.  By the time of her retirement in 1939, Ms. Fuller had paid a total of $24.75 into the Social Security trust fund.

Ms. Fuller was blessed with longevity, and lived to the age of 100 years, passing away in 1975.  Astonishingly, over the last 46 years of her life, Ms. Fuller collected Social Security benefits totaling $22,888.92 – more than 900x the amount of her total contributions.  Ms. Fuller’s first benefit check alone was almost equal to the cumulative total of all payroll tax contributions that Ms. Fuller had ever made!

I do not recount this story to be disparaging to Ms. Fuller in any way, but her story should be concerning to anyone with a vested interest in the solvency of our nation and our ability to care for an aging population.  It is immediately obvious that the benefits paid to Ms. Fuller simply didn’t come from her initial contributions, plus interest.  After all, Ms. Fuller received tens of thousands of dollars in Social Security benefits over more than 4 decades, despite contributing only $25 into the plan.  Ms. Fuller’s benefit checks could only total such a large sum because they were funded by the contributions of others who we working during from the 1940’s through the 1970’s, contributing payroll taxes all along the way.  Sound familiar?  Remember, in a Ponzi scheme, the returns that are paid to the early participants in the fraud come from the money that is provided by the later participants in the fraud.

It is important to recognize that all Ponzi schemes are destined to fail – it’s simply a matter of time.  A Ponzi scheme can only remain stable as long as the money from new participants (workers) coming into the system exceeds the payments going to those that are cashing out (retirees).  A typical Ponzi scheme is destined to fail because eventually it becomes impossible to find increasing numbers of new people to participate and the money is exhausted.  Of course, Social Security is not a typical Ponzi scheme and it won’t fail in this conventional manner, but it will eventually be restructured in a major way and therefore fail to provide the level of benefits that are currently promised to the majority of the working age population.

At the inception of Social Security in the 1930’s, employees paid only 1.0% of their earnings into the plan and adults had an average life expectancy of 78 years.  Today, most working adults pay 6.2% of their earnings into the plan and have an average life expectancy of 84 years.  Furthermore, the original social security plan did not pay survivor benefits to spouses, nor to children or to the disabled, as it does today.  In other words, Social Security is now responsible for paying more and more benefits to individuals that never made contributions at all.  Also, as you probably know, Social Security benefits are indexed for inflation through cost-of-living-adjustments.  It is interesting to note that if the retirement age had been indexed for changes in life expectancy in a similar fashion, the current eligibility age for collecting benefits would be 71 years.

We are now at the inception of a wave of retiring workers who will begin drawing Social Security benefits that have been over-promised.  Going forward, these retirees will receive benefits that are funded by a comparatively smaller working population, most of whom already contribute 6.2% of their income into the system (notwithstanding the temporary payroll tax cut during 2011).  In order for the system to remain stable, the contributions must be brought back in line with the distributions and this can only happen in one of two ways: cut benefits or increase payroll taxes (or both).  This situation clearly is not the fault of the retirees or other beneficiaries; it is the fault of the government for mismanaging the actuarial assets and liabilities of the plan.  Had the necessary adjustments to the plan been made years ago the effects would have been more modest and less economically consequential.  But the time for moderate change has now passed.  If we intend to save Social Security and minimize the impact to current and soon-to-be retirees, the restructuring must involve larger and more consequential actions.  The sooner the better.

Hopefully this gives us a glimpse into why entitlement spending lies at the core of the nation’s growing debt problem.  And we haven’t even begun to talk about Medicare yet…