The Myth of Compound Interest

Open up any introductory economics text, Samuelson, for instance, and there'll be at least a whole chapter on interest rates and compounding of same as the salvation of mankind.  The charging of interest isn't, and wasn't, universally accepted.  Islam, famously, sort of prohibits it.  What isn't as well known, due I suspect to outright bigotry is, Judiasm held the same belief. 

Thanks to Shylock, the dark ages, and discrimination, Jews became synonomous with usury.  But that's another episode.  This one discusses where the notion comes from, and whether it makes sense in the real world.

Economists, famously, define interest as "the time value of money", which just means that *it's obvious* that a dollar next year is worth less than a dollar today.  You can spend the dollar today, today; but not the dollar next year.  So, how much value is "the time value of money"?  Nobody knows.  Is it 1%, 10%, or 30%????  Nobody can say.  The reason is:  it's a different number for each person.  Intuitively, the more money you have, the less need you have for money today, or next year, so, based on need, the wealthier you are, the lower your "time value of money".  Of course, rich folk are mostly the most demanding of interest income.  They're lazy bastards, of course, wishing to have an income without providing any useful output to the society.  That is the basic idea behind Islamic and Judaic bans. 

But, there is a concrete application.  This is, as economists call it, *real investment*.  Economists (Tea Bagger fools excepted) recognize that economies are based on physical production, not financial manipulation.  The issue has been discussed somewhat more since the start of The Great Recession:  the number I recall is that leading up to The Great Recession, 30% of corporate profit was the result of money manipulation (finance, as it's adherents prefer to call it). 

The problem with finance as a source of profit is that finance is a zero-sum game.  Put another way, profit to finance comes from the flow of money from savers to borrowers.  There is no other source.  It is the skim off the top.  Profit to finance means fewer dollars to borrowers, and fewer returned to savers.

So, how do economists justify compound interest?  If one starts with a premise of physical production, then a return on physical investment can be calculated without recourse to "the time value of money".  The return is purely the result of greater production due to the new physical plant/machinery/etc.  Might you see where this is going?  Here, take my hand.

During the subprime housing frenzy, large money flows went into American houses.  They got larger, on larger plots of land.  They cost more to build.  The builders made out like bandits.  Those money flows didn't go into the production of any salable good or service.  Did you know that the USofA is one of the very few countries which subsidizes housing mortgages through the tax code?  Or that most home mortgage holders (households) *don't* get that gratuity because they don't itemize?  "The Tax Policy Center crunched the numbers and found that a complete elimination of the mortgage interest deduction would raise taxes on only 21.5% of middle-income workers, with an average increase of just $215 a year. The bulk of the increase would fall on the top 10% of wage earners. It's about as progressive as it gets."  Cited here.

Krugman quotes himself:  the American economy devolved into selling houses with Chinese money.  There isn't any real return on housing.  The only way to pay the interest on one's mortgage:  buy less other stuff or hope that one's real wages rise over time.  The key here is "real wages".  Real wages only rise when the economy gains productivity and those gains trickle down to wage earners.  Since Reagan, we have had lots of the former but none of the latter.  Thus the subprime juggling.

On the other hand, if Joe's Machine Shop spends $10,000 on a new milling machine, Joe can, if he wants, figure out exactly how much better off his production is.  Now, that calculation gets muddied by various tax code factors.  If the increase in productivity nets Joe more than the vig by the bank, then he might buy the milling machine.  But the decision has nothing to do with Joe's notion of "the time value of money", only whether he sees a net cash flow from the machine.  The amount of vig he owes the bank makes a difference, but this isn't his determination of "the time value of money", only his banker's.

Why should compound interest exist in the real world?  From an accounting point of view, anything can be done.  The rules of accounting are wholly made up by humans.  Humans decided what the rules are (frequently flouted, at that).  The real return on physical investment is a function purely of the production process improvement.  Compounding?  The assumption is that there are an infinite number of real physical investments available for all time.  If that sounds a bit like a Ponzi scheme, you're right.

So, what is "the time value of money"?  My recollection from school, was about 2%; the historical long term average of the long term interest rate.  And, contrary to popular belief, long term rates aren't necessarily higher than short term.  This paper discusses.  It's a read-only, so I couldn't get a juicy quote.

Which brings us full circle:  why is there compound interest?  In large part, it is a fiction of the banks.  The only real interest rate is the return on physical investment, which is devilishly difficult to calculate.  There certainly isn't a universal value, and that's the whole point.  The artificial rates created by banks and governments are, by definition, divorced from reality.  The larger problem created by the Right Wingnuts is the conflation of monetary interest rates with real return on investment.  Moreover, interest paid for non-production expenditures (housing, highways, and hand grenades) is money wasted, from an economic point of view.  Dissertations have been written on calculating "imputed interest" for such things as public works.  How much productivity gain is there from a bullet train between Beijing and Shanghai?  Or an interstate highway system in the US?  One might argue that the former does good, while the latter does bad; the argument resting largely on externalities.  The return on financial instruments is equally ambiguous, unless they are explicitly tied to physical investments which increase production; the subprime nonsense makes that quite clear.  Microsoft Word on every company PC isn't necessarily a productive expenditure either; lots of studies have been done, many concluding that fancy word processing actually reduces useful time spent.  The user gets fascinated with eye-candy, ignoring the quality of the content.

With the Fed (and the EU) keeping nominal interest rates near 0, one expects that real investment should soar, shouldn't it?  Put all that cheap money to good use?  Hasn't happened.  Corporates hoard cash, complain about being taxed (lowest in at least 50 years), and do nothing.  Well, wait for massive deflation, of course.  Read about the Phat Man in Famine.