COMPOUND INTEREST

COMPOUND INTEREST

http://michael-hudson.com/2007/08/why-the-miracle-of-compound-interest-leads-to-financial-crises/ 

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WHY THE "MIRACLE OF COMPOUND INTEREST" LEADS TO ... - Michael Hudson

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Aug 27, 2007 - The economics of compound interest ... This simple formula works for rates up to 20 percent, which happens to be the rate of interest ..... [6] Palgrave's Dictionary of Political Economy, citing the Annual Register (1797) and ...

Looking at today’s global economy, the obvious question to ask is why more economies haven’t achieved the technological potential reached by North America and Europe. Given the fact that technology is fairly universal, why aren’t all nations operating up to this potential?

Most of the papers produced by the working group here in Oslo have emphasized increasing returns and the technological basis for comparative advantage. Reviving the 19th-century writings of German and American national economists, Reinert and his colleagues have reviewed the arguments why latecomers may require protective tariffs, subsidies and public infrastructure investment to catch up, especially in the spheres of education and public health. Increasing returns tend to widen the competitive advantage of leading industrial nations (whose agriculture has achieved equally remarkable productivity gains by being industrialized into agribusiness). The effect is to render labor, capital and technology in the less developed periphery obsolete, under-educated and under-supplied with public infrastructure. The result is a chronic trade and payments deficit, building up over time to impose a heavy foreign-debt burden.

The technological core of economies is wrapped in a framework of property laws, financial practices and taxes that vary sharply from one country to another. This institutional context imposes an extractive overhead of property claims and debt service that are largely a vestige of the conquest of Europe by the Vikings and their kin, who appropriated the public commons and levied property rents. These military conquerors were followed by the Templars and Italian bankers, who legitimized the charging of interest and standing royal war debts.

The financial counterpart to increasing returns in the production sector is the “magic of compound interest” – the tendency of debts to multiply by purely mathematical principles, independent of the “real” economy’s ability to pay. Early analysts of compound interest pointed out that the debt overhead tends to expand autonomously, eating into the “real” economy, slowing it down and polarizing property and income by diverting revenue away from production and consumption to pay creditors.

What distinguishes the “other canon” from today’s dominant orthodoxy is its rejection of the assumption that economies tend to stabilize automatically in a fair and equitable balance, and hence do not require government regulation – and that public enterprises operate more efficiently if transferred into private hands. Accusing government planning of being inherently inefficient and hence needlessly costly, today’s self-proclaimed neoliberals claim that the dynamics of free markets will overpower whatever government planners try to impose.

Defending the need for active public policy, the other canon finds that such a balance requires that markets be shaped by selective taxation, public regulation, subsidies and infrastructure investment. Privatization of public enterprises and other parts of the public domain adds to their cost of production by building in financial charges and capital gains by owners, and higher payments to the financial managers who end up as planners of these assets.

According to this approach, the slogan of “free markets” is merely a euphemism for centralizing planning power in the hands of financial and other vested interests that are seeking to break away (that is, “free”) of oversight, regulation and taxation by elected officials. They seek above all to make central banks independent – that is, controlled by the commercial banking interest – and to concentrate trade and tax policy in the hands of the IMF and World Bank globally, and domestically in an Executive Branch controlled by financial and property lobbyists. Thanks largely to the privatization of election financing and its rising media advertising costs in today’s political campaigns, the vested property and financial interests have succeeded in un-taxing and deregulating themselves. This is just the opposite policy from that advocated by the classical liberal political economists from Adam Smith through John Stuart Mill. To these “original” liberals, a free market meant a market free of free lunches for the rentier interests. Their idea of freedom was one of equal opportunity for all economic players.

Given the fact that all market participants engage in forward planning of one sort or another, the great political question concerns just who is to do the planning. To the extent that government relinquishes this role, planning passes into the hands of the economy’s financial managers. When the government steps aside, they pick up the slack. Unfortunately, their time frame is shorter and their aims are more narrowly self-serving than those of public officials. Most seriously of all, they seek the economic rent and extractive financial returns that classical liberals and Progressive-Era reformers sought to minimize by government regulation or taxation.

Today’s pattern of economic development and taxation is not what most 19th-century economists expected to see. Viewing economic evolution in terms of rising productive powers – and hence, living standards – they thought that economic management would pass naturally into the hands of industrial engineers under a regime of democratic parliamentary reform. They also expected governments to play a growing role, above all in by providing the infrastructure needed to make domestic industry and agriculture more competitive, and to prevent monopolies and other special interests from extracting rent or otherwise profiteering from the economy at large.

The classical economists characterized economic rent as “unearned income,” and John Stuart Mill called capital gains an “unearned increment,” best typified by the rising land values that accrued to landlords “in their sleep.” The aim was for prices to reflect only the returns to socially and technologically necessary costs of production, and to maintain an economy in which after-tax income is earned, not achieved by property privileges of special interests. Taxes levied on these rentier gains would be paid out of the economy’s “free lunch.” Rather than raising prices, taxing these returns keeps land values and the price of stocks in monopolies low.

To defend their moral and fiscal right to this income, and to minimize public regulation and taxation of price gains for land, stocks and bonds, the rentier interests depicted their returns not as extractive but as a bona fide cost of doing business, and hence earned. They even went so far as to claim that these returns acted as the mainspring of economic growth. On this basis the rentier lobbies in modern times have advocated that taxes should be levied on labor, not on the land’s economic rent or the extortionate prices and related gains demanded by monopolies.

In this paper I want to discuss the financial sector’s tendency to dominate, deflate and polarize economies, thwarting economic potential. Understanding these financial dynamics is essential to explain why all nations are not operating up to the technological potential toward which classical liberalism aimed, and why the world economy is polarizing, as are domestic economies even in the most advanced industrial nations.

THE ECONOMICS OF COMPOUND INTEREST

Financial returns therefore probably accumulated in the hands of lenders more rapidly than they could find commercial opportunities. This phenomenon has proved fateful for lending in today’s capital markets to spill over to increasingly risky ventures. Antiquity’s laws said that merchants did not have to pay their backers if their ship was robbed by pirates or sunk, or if their caravan was robbed. Creditors thus shared in the risk of the merchants they financed (a practice that Islamic law revived). Near Eastern rulers resolved the tendency toward debt instability by annulling personal and agrarian debts when large numbers of cultivators were unable to pay as a result of flooding, drought or military disruption. This subordinated creditor claims to the economy’s ability to pay.

In the modern epoch, J. P. Morgan and John D. Rockefeller are reported to have called the principle of compound interest the Eighth Wonder of the World. The late 19th-century writer Michael Flürscheim described Napoleon as voicing a similar idea upon being shown an interest table and remarking: “The deadly facts herein lead me to wonder that this monster Interest has not devoured the whole human race.” Flürscheim commented: “It would have done so long ago if bankruptcy and revolution had not been counter-poisons.” And that is just the point, of course. Something must give when the mathematics of interest-bearing debt overwhelms the economy’s ability to pay. For awhile the growing debt burden may be met by selling off or forfeiting property to creditors, but an active public policy response is needed to save the economy’s land and natural resources, mines and public monopolies, physical capital and other productive assets from being lost to creditors.

To illustrate the dynamic at work, Flürscheim composed an allegory pitting the Spirit of Invention against the Demon of Interest and his offspring, Compound Interest, in a battle to see whose powers were stronger. The Spirit of Invention had an army of tools and machines, water power, air and wind power, fire and steam power to drive machinery. But Flürscheim asked whether its minions really would bring about a golden era, or whether this power could be conquered by finance capital and made to serve it by paying tribute rather than serving mankind in the form of higher living standards. To illustrate the principle at work he related a Persian proverb about a Shah who wanted to reward the inventor of chess, and asked what the man would like. The man asked “as his only reward that the Shah would give him a single grain of corn, which was to be put on the first square of the chess-board, and to be doubled on each successive square; which, to the surprise of the king, produced an amount larger than the treasures of his whole kingdom could buy” as the amount doubled on each of the board’s 64 squares.

For the first row of the board the amount of grain being measured out was modest: 1, 2, 4, 8, 16, 32, 64, 128 grains, reaching the power of 27 but still not even a cupful. By the second row, it became a large sackful: 215, or, 32,768 grains. It soon became obvious that to fill the entire 64 squares – eight rows – would 2123, far more than n the kingdom or, for that matter, the whole world possessed. The moral, Flürscheim concluded, was that in due course the mathematics of compound interest was “much more powerful than the Spirit of Invention,” ending up enslaving it.[5] 

The political fight in nearly every economy for thousands of years has been over whose interests must be sacrificed in the face of the incompatibility between financial and economic expansion paths. Something has to give, and until quite recently creditors have lost. This is the point that modern economists and futurists fail to appreciate. Financial claims run ahead of the economy’s ability to produce and pay. Expectations that interest payments can keep on mounting up are “fictitious,” as Marx and other 19th-century critics put it. When indebted economies and their governments cannot pay, bankers and investors call in their loans and foreclose.

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Financial claims run ahead of the economy’s ability to produce and pay.

Expectations that interest payments can keep on mounting up are “fictitious. When indebted economies and their governments cannot pay, bankers and investors call in their loans and foreclose.

“Things that can’t go on forever, don’t.”.  The accrual of savings (that is, debts) is constrained by the economy’s inability to carry these debts. Recognizing that no society’s productive powers could long support interest-bearing debt growing at compound rates.

Marx regards capital as a self‑acting thing, without any regard to the conditions of reproduction of labour, as a mere self‑increasing number,” subject to the growth formula: Surplus = Capital (1 + interest rate)

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Compound interest is related to time:  Under William Pitt the government calculated that at compound interest even as low as 4 percent, the trust would grow so enormous as to own the entire public debt by the time a century had elapsed.

British interest rates had the effect of doubling the cash deposits of the oil-producers in only five years, or 16.3 times in twenty years! …

The moral is that no matter how greatly technology might increase humanity’s productive powers, the revenue it produced would be absorbed and overtaken by the growth of debt multiplying at compound interest.

Neoliberal “free market” canon	Classical liberal canon
If left alone, markets settle at a fair equilibrium in which all parties have equal opportunity.	Economies tend to polarize unless governments act to prevent free lunches by vested interests.
The MV=PT formula views money as being spent on goods and services, and hence sees more money as inflating consumer prices.	Most credit is created for spending on real estate, stocks and bonds. Hence, what is inflated are primarily asset prices.
Analyzes the “real” economy as if it operates on the basis of barter without the buildup of interest-bearing and property-rent claims.	Emphasizes the distinction between the “real” economy’s S-curve expansion path and the exponential growth of debt.
Credit is invested productively, enabling borrowers to repay loans and interest.	Most bank credit is unproductive, imposing a debt burden that diverts income away from buying goods and services.
Borrowers use the loan proceeds to make enough money to pay off their loans and keep a profit for themselves.	Under a regime of asset-price inflation, loans are paid off increasingly out of new borrowing against collateral that is rising in price.
Bank lending increases investment to hire labor to produce more goods and services, supplying more output and keeping commodity prices down while raising living standards.	Mortgage credit which is used to bid up real estate prices, or financial credit to bid up prices for bonds and stocks. In the ends, loans are paid off mainly out of capital gains (asset-price inflation).
High debt leverage increases the return on equity, spurring more wealth creation.	High debt leverage increases the debt overhead, and inflates asset prices, obliging property buyers to go deeper into debt.
“Supply-side” economists claim that loans spur more investment, and hence more profits to tax.	Loans reduce tax revenues, because interest is a tax-deductible expense. This shifts the fiscal burden onto labor.
Cutting taxes on property income and capital gains lowers the cost of doing business and hence frees more income for investment.	Tax cuts free income to be pledged to creditors for higher loans to buy real estate, financial securities and entire companies. This raises asset prices.
Low wages make economies more competitive, assuming that there is no feedback between wages and productivity.	High productivity requires high wages and living standards.

Financialization as an extended Ponzi phase of the credit cycle

Every country has seen its ratio of debt to national income rise in recent years. Most bank credit – some 70 percent – is for real estate mortgages, reflecting the fact that real estate remains the economy’s largest asset even in today’s industrialized world. These loans increase the volume of debt attached to the economy’s property and income streams. Also rising are corporate debt/equity ratios. Bankers begin to extend credit against what they project that property prices will be worth in the future, given current rates of asset-price inflation. The dependence on credit increases the debt burden.

Minsky described this as the third and final “Ponzi” phase of the financial cycle. The term was coined to describe Carlo Ponzi’s practice in the 1920s of promising much higher returns to investors than they could earn elsewhere. He pretended to make arbitrage gains by buying international postage stamps and cashing them in for different currencies, profiting from shifts currency values that were not reflected in the International Postal Union’s price policies. In reality, he didn’t use the money for this purpose at all, but simply repaid early subscribers to his scheme out of money that new investors were putting in, believing that his high payouts to early investors reflected actual trading gains.

It seems ironic at first glance – but quite logical when one stops to think about it – that the largest and presumably most secure borrowers are the first that are able to enter into this “Ponzi” stage of being able to most easily add the interest onto their existing debt balance, year after year. The irony is that precisely by being so large and prestigious, the leading classes of borrowers tend to become insolvent faster than anyone else: the U.S. Government, foreign governments, real estate investors, and the biggest banks.

The world’s largest borrower is the U.S. Government. Its debt now amounts to some $— trillion. It has been built up by running budget deficits – at first for military spending, and since 1980 by slashing taxes on the higher wealth brackets, which have become the largest backers of political campaigns. One could say that instead of taxing the rich as formerly in accordance with the philosophy of progressive taxation, the government now borrows from them and pays them interest.

Most of the growth in America’s public debt since the nation went off gold in 1971 has not been financed by U.S. savers, but by foreign central banks, which find themselves flooded with dollars thrown off by America’s foreign military spending and widening trade deficit. The problem is that after central banks agreed in 1971 to stop settling balance-of-payments deficits in gold, the only alternative seemed to be to keep their central-bank reserves in the form of loans to the U.S. Government, recycling their balance-of-payments surpluses by buying U.S. Treasury bonds. America’s foreign debt has soared far beyond its ability to pay in any foreseeable future, even if its politicians were willing to do so (which they are not).

One result is that despite the fact that most Asian and European voters oppose the U.S. invasion of Iraq and related global military buildup, the international financial system has been set up in a way that obliges foreign governments to finance it. In fact, the United States is running up about $50 billion in interest charges each year to countries such as China – and simply adds this amount to the bill it owes.

This is how Brazil and other Latin American governments operated in the financial sphere before the Third World “debt bomb” exploded in 1982 when Mexico teetered on the brink of default. Each year they would ask the international bank consortium to lend enough more to cover the interest falling due – in effect, to add the interest onto the loan balance. Their debts grew at compound interest, doubling and redoubling exponentially every ten to twelve years at the then-normal annual interest rate of 6 to 7 percent. In effect, banks were paying interest to themselves, using Third World debtors as vehicles in what was becoming an increasingly fictitious global economy. It was fictitious because there was no way that the debts really could be paid. They had grown beyond the point where this was feasible economically, to say nothing of politically.

For governments less powerful than the United States, the price of getting the world’s commercial banks to keep rolling over their loans was to submit to strict political conditions laid down by U.S. diplomats. To qualify as a “good client,” third world debtors had to pursue deflationary monetary policies laid down by the International Monetary Fund and trade-dependency policies dictated by the World Bank. These programs made their trade balance worse and worse, thereby preventing them from working out their debts in practice. This made the global economy increasingly polarized and unstable.

Lending to these countries resumed after §990 to debtor governments that agreed to obey creditor demands that they pay their debts by selling off their public enterprises and national infrastructure. These sales led to much higher prices charged for basic services, impairing their competitiveness and hence making a future international debt crisis inevitable once again.

After governments, the leading borrowers are real estate investors. They have followed the same strategy as Third World governments, and bankers have been equally facilitating. Speculators keep ahead of the game as long as property prices increase at a higher rate than the rate of interest charged by the banker, so that they can sell their asset at a capital gain. The idea is to use “other peoples’ money” – or more accurately, bank credit – which is created electronically rather than representing savings that people have built up.

Bankers succumb to a bubble mentality, going so far as to make “negative mortgages” – debts that are not paid off at all, but keep adding the accrual of interest to the debt burden. Investors buy real estate and other assets by taking out loans so large that the revenue their collateral generates does not even suffice to carry the interest charges, not to mention paying down the principal. But real estate has become so important to their bankers that when their rental income fails to pay the interest charges falling due, most bankers are willing to be patient and simply let the debt service mount up. The interest that falls due is simply borrowed – in effect, added onto the debt in an exponentially rising curve.

The hope of lenders and borrowers alike is that the latter can sell their homes or office buildings at a high enough price to cover the mortgage charges and still keep a “capital gain” (mainly the land’s site value beneath these properties) for themselves. Well-meaning academics and journalists with the usual array of prestigious credentials are hired to explain that all this adds to “capital formation” and “wealth creation,” and hence should be taxed at only half the rate at which earned income – wages and profits – is taxed. This tax favoritism for debt-financed speculation shifts the fiscal burden onto labor and industry.

But real estate prices may plunge when the debt overhead grows too large, leaving property owners with negative equity. Many simply walk away from their property, leaving the banks holding the bag – a portfolio of bad debts. This may leave banks with negative equity if they owe more to their depositors and other creditors (other banks, the government’s central banks, holders of their own bonds and commercial paper) than their portfolio of loans is worth.

This was the point at which Citibank and Chase Manhattan were said to be in back in the credit crunch of 1980. They saved themselves by explaining to financial officials (mainly their own former managers) that their failure would cause such widespread dislocations that it would bring down the economy, if not the government currently in office. They were deemed “too big to fail,” and were allowed to rebuild their asset base and capital reserves by holding the interest rates that they charged for consumer loans high – around 20 percent – throughout the 1980s and into the 1990s, even as normal interest rates plunged to 5 percent.

For the economy at large – for businesses and individuals lacking the economic clout to keep the banks letting their interest arrears mount up – most borrowers are dependent on the banking system’s own expansionist ambitions. The result is a confluence of interest that makes the entire economy look like a Ponzi scheme. The largest banks for their part claim that they are “too big to fail,” much as the U.S. Government has told foreign central banks and other dollar holders. The greatest need for such operations is enough new members to put in enough new money to pay investors who want to “cash out” and realize the return that has been promised. In this case the bankers play the role of demanding money – by stopping the practice of lending borrowers the credit to pay their interest charges.

“Ponzi borrowers” need their assets to rise steadily in price so as to keep refinancing their debts at high enough levels to cover the interest that accumulates. This exponential growth becomes more and more difficult to achieve. Defaults occur if assets fail to appreciate or begin to lose value. This leaves investors in such schemes – and ultimately, banks themselves – holding the bag. That is what occurred in Japan after 1990, and in the United States in 2007. It is the third and final stage of credit flaming out. And as F. Scott Fitzgerald put it, flaming youth ends when there is no more money to burn.

Asset-price inflation as official policy

The largest economic sector is real estate, and it remains the key to any economy’s long-term dynamics. The U.S. real estate bubble of the late 1990s and early 2000s illustrates a repertory of tactics employed by the central bank to inflate asset prices. Three tactics are classic: (1) lowering interest rates; (2) stretching out debt maturities; (3) reducing the amount of money (“equity”) that asset buyers must put down. As Alan Greenspan recommended, homeowners borrowed against the rising market price of their real estate to maintain consumption levels that their earnings no longer were sustaining. [CHARTS] 

The political and fiscal dimension of financialization

As the financial sector becomes richer, it translates its economic power into political power, backing lawmakers who shift taxes off property and finance onto labor and industry, depressing the domestic market. Indeed, financialization requires the economic process to be increasingly politicized in order to keep evolving. Recognizing that the growth of debt entails tightening bankruptcy laws independent from democratic oversight and control, and indeed actively militates against it, the financial sector’s political lobbies and their academic cheerleaders demand that central banks be made independent from democratic political overrides.

JUNK ECONOMICS TO ENDORSE THE BUBBLE ECONOMY

I almost hesitate to use the term “parasitized” in an academic analysis, but biology provides a repertory of how the financial sector works to take over the economy’s policy-making. I use the term “parasitic finance” to explain how the financialization process intellectualizes itself. The strategy of parasites in nature is not simply to drain their host’s nourishment for themselves, but to take over its brain – its “planning function,” so to speak – so that the host imagines that it is feeding itself while actually it is nourishing and protecting its free rider.

Financialization transforms economic thought itself, including the economy’s statistical self-portrait. The classical 19th-century economists would have viewed it as an unproductive distortion of the “real” economy of industry, agriculture and commerce. Such a value judgment needs to be changed (“modernized”) in order for financialization to promote the idea of asset-price inflation as “wealth creation” for the population at large to make them willing and even eager to go deeper into debt in the belief that this is the easiest path to wealth, conceived as a positive net worth of inflated asset valuations relative to debt. But the financial sector’s rake-off is described as “providing a service,” not as a zero-sum transfer payment.

BETRAYING THE CONCEPT OF ECONOMIC LIBERTY AND FREE MARKETS

A rising proportion of debts cannot be paid, including government debt (especially foreign debt), real estate speculation, corporate takeover debts and many personal debts. The economy’s shape changes as debtors default, creditors foreclose and governments are forced to privatize the public domain as an alternative to defaulting or repudiating their debts outright. All this is called a “free market,” as if the only form of economic freedom is from government.

It would better be viewed as a free lunch for the financial and property sector. It is a travesty of the historical idea of liberty from the third millennium BC through classical antiquity, when the meaning of liberty connoted primarily freedom from debt bondage. This is the liberty to which early Judaism and Christianity referred. It survives in the inscription on America’s Liberty Bell in Philadelphia from Leviticus 25: “Proclaim liberty throughout the land, and to all the inhabitants thereof.” The Hebrew word corresponding to “liberty” in this inscription was d’r’r (deror), cognate to Babylonian andurarum, the word rulers used for Clean Slates. These royal proclamations comprised three interrelated policies: cancellation of personal debts, freedom for bondservants who were pledged to creditors as collateral to return home to their families of origin, and return to their customary holders of land and crop rights that had been pledged to creditors as collateral. Viewed in this long-term perspective, financial freedom for government means the right to infringe on the liberty of debtors and indeed, entire debtor economies.