Usury & compound interest
The All-Devouring “Magic of Compound Interest”
That terminator is out there. It can’t be bargained with. It can’t be reasoned with. It doesn’t feel pity, or remorse, or fear. And it absolutely will not stop, ever, until you are dead.
— Kyle Reese, describing the character of “The Terminator” (1984)
— Kyle Reese, describing the character of “The Terminator” (1984)
Driven by the mathematics of compound interest – savings lent out to grow exponentially – the overgrowth of debt is at the root of today’s economic crisis. Creditors make money by leaving their savings to accrue interest, doubling and redoubling their claims on the economy. This dynamic draws more and more control over labor, land, industry and tax revenue into the hands of creditors, concentrating property ownership and government in their hands. The way societies have coped with this deepening indebtedness should be the starting point of financial theorizing.
Money is not a “factor of production.” It is a claim on the output or income that others produce. Debtors do the work, not the lenders. Before a formal market for wage labor developed in antiquity, money lending was the major way to obtain the services of bondservants who were compelled to work off the interest that was owed. Debtors’ family members were pledged to their creditors. In India, and many other parts of the world, debt peonage still persists as a way to force labor to work for their creditors.
In a similar way, getting inducing landholders into debt was the first step to pry away their subsistence lands, beaching archaic communalistic land tenure systems. In this respect creditors are like landlords, obtaining the labor of others and growing richer in the way that J. S. Mill described: “in their sleep,” without working.
The problem of debts growing faster than the economy has been acknowledged by practically every society. Religious leaders have warned that maintaining a viable economy requires keeping creditors in check. That is why early Christianity and Islam took the radical step of banning the charging of interest altogether, even for commercial loans. It is why Judaism placed the Jubilee Year’s debt cancellation at the core of Mosaic Law, based on a Babylonian practice extending back to 2000 BC, and to the Sumerian tradition in the millennium before that. Calculating how money lent out at interest doubles and redoubles was taught to scribal students in Sumer and Babylonia employed in palace and temple bookkeeping.
Mesopotamia’s standard commercial interest rate from around 2500 BC through the Neo-Babylonian epoch in the first millennium was high – the equivalent of 20 percent annually. This rate was not reached in modern times until the prime loan rate by U.S. banks peaked at 20 percent in 1980, causing a crisis. Yet this rate remained stable for more than two thousand years for contracts between financial backers and commercial traders or other entrepreneurs. The rate did not vary to reflect profit levels or the ability to pay. It was not set by “market” supply and demand, but was an administered price set as a matter of mathematical convenience by the initial creditors: the Sumerian temples and, after around 2750 BC, the palaces that gained dominance.
A mina-weight of silver was set as equal in value to as “bushel” of grain. And just as the bushel was divided into 60 “quarts,” so a mina-weight of silver was divided into 60 shekels. It was on this sexagesimal basis that temples set the rate of interest simply for ease of calculation – at 1 shekel per month, 12 shekels in a year, 60 shekels in five years.
The exponential doubling and redoubling of debt
Any rate of interest implies a doubling time – the time it takes for interest payments to grow as large as the original principal. A Babylonian scribal exercise circa 2000 BC asked the student to calculate how long it will take for a mina of silver to double at the normal simple interest rate of one shekel per mina per month. The answer is five years, the typical time period for backers to lend money to traders embarking on voyages. Contracts for consignments to be traded for silver or other imports typically were for five years (60 months), so a mina lent out at this rate would produce 60 shekels in five years, doubling the original principal. Assyrian loan contracts of the period typically called for investors to advance 2 minas of gold, getting back 4 in five years.
The idea of such exponential growth is expressed in an Egyptian proverb: “If wealth is placed where it bears interest, it comes back to you redoubled.” A Babylonian image compared making a loan to having a baby. This analogy reflects the fact that the word for “interest” in every ancient language meant a newborn: a goat-kind (mash) in Sumerian, or a young calf: tokos in Greek or foenus in Latin. The “newborn” paid as interest was born of silver or gold, not from borrowed cattle (as some economists once believed, missing the metaphor at work). What was born was the “baby” fraction of the principal, 1/60th each month. (In Greece, interest was due on the new moon.) The growth was purely mathematical with a “gestation period” for doubling dependent on the interest rate.
The concept goes back to Sumer in the third millennium BC, which already had a term mashmash, “interest (mash) on the interest.” Students were asked to calculate how long it will take for one mina to multiply 64 times, that is, 26 – in other words, six doubling times of five years each. The solution involves calculating powers of 2 (22 = 4, 23 = 8 and so forth). A mina multiplies fourfold in 10 years (two gestation periods), eightfold in 15 years (three periods), sixteenfold in 20 years (four periods), and 64 times in 30 years. The 30-year span consisted of six fiveyear doubling periods.
Such rates of growth are impossible to sustain over time. Automatic compounding of arrears owed on debts was not allowed, so investors had to find a new venture at the end of each typical five-year loan period, or else draw up a new contract. With the passage of time it must have become harder to find ventures to keep on doubling their savings.
Martin Luther depicted usurers scheming “to amass wealth and get rich, to be lazy and idle and live in luxury on the labor of others.” The growing mass of usurious claims was depicted graphically as a “great huge monster … who lays waste all … Cacus.” Imbuing victims with an insatiable desire for money, Cacus encouraged an insatiable greed that “would eat up the world in a few years.” A “usurer and money-glutton … would have the whole world perish of hunger and thirst, misery and want, so far as in him lies, so that he may have all to himself, and every one may receive from him as from a God, and be his serf for ever. … For Cacus means the villain that is a pious usurer, and steals, robs, eats everything.”
The mathematical calculation of interest-bearing debt growing in this way over long periods was greatly simplified in 1614 by the Scottish mathematician John Napier’s invention of logarithms (literally “the arithmetic of ratios,” logos in Greek). Describing the exponential growth of debt in his second book, Robdologia (1617), Napier illustrated his principle by means of a chessboard on which each square doubled the number assigned to the preceding one, until all sixty-four squares were doubled – that is, 263 after the first doubling.
Three centuries later the 19th century German economist, Michael Flürscheim, cast this exponential doubling and redoubling principle into the form of a Persian proverb telling of a Shah who wished to reward a subject who had invented chess, and asked what he would like. The man asked only “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,” until all sixty-four squares were filled with grain. Upon calculating 64 doublings of each square from the preceding, starting from the first gain and proceeding 1, 2, 4, 8, 16, 32, 64 and so on.
At first the compounding of grain remained well within the physical ability of the kingdom to pay, even after twenty squares were passed. But by the time the hypothetical chessboard was filled halfway, the compounding was growing by leaps and bounds. The Shah realized that this he had promised “an amount larger than what the treasures of his whole kingdom could buy.”
The moral is that no matter how much technology increases humanity’s productive powers, the revenue it produces will be overtaken by the growth of debt multiplying at compound interest. The major source of loanable funds is repayments on existing loans, re-lent to finance yet new debts – often on an increasingly risky basis as the repertory of “sound projects” is exhausted.
Strictly speaking, it is savings that compound, not debts themselves. Each individual debt is settled one way or another, but creditors recycle their interest and amortization into new interest-bearing loans. The only problem for savers is to find enough debtors to take on new obligations.
The Rule of 72
A mathematical principle called the “Rule of 72” provides a quick way to calculate such doubling times: Divide 72 by any given rate of interest, and you have the doubling time. To double money at 8 percent annual interest, divide 72 by 8.
The answer is 9 years. In another 9 years the original principal will have multiplied fourfold, and in 27 years it will have grown to eight times the original sum. A loan at 6 percent doubles in 12 years, and at 4 percent in 18 years. This rule provides a quick way to approximate the number of years needed for savings accounts or prices to double at a given compound rate of increase.
The exponential growth of savings (= other peoples’ debts)
One of Adam Smith’s contemporaries, the Anglican minister and actuarial mathematician Richard Price, graphically explained the seemingly magical nature of how debts multiplied exponentially. As he described in his 1772 Appeal to the Public on the Subject of the National Debt:
Money bearing compound interest increases at first slowly. But, the rate of increase being continually accelerated, it becomes in some time so rapid, as to mock all the powers of the imagination. One penny, put out at our Saviour’s birth at 5% compound interest, would, before this time, have increased to a greater sum than would be obtained in a 150 millions of Earths, all solid gold. But if put out to simple interest, it would, in the same time, have amounted to no more than 7 shillings 4½d.
In his Observations on Reversionary Payments, first published in 1769 and running through six editions by 1803, Price elaborated how the rate of multiplication would be even higher at 6 percent: “A shilling put out at 6% compound interest at our Saviour’s birth would … have increased to a greater sum than the whole solar system could hold, supposing it a sphere equal in diameter to the diameter of Saturn’s orbit.”
Rather naïvely, Price suggested that Britain’s government make use of this exponential principle to pay off the public debt by creating a public fund that itself would grow at compound interest (called a sinking fund). The idea had been proposed a half century earlier by Nathaniel Gould, a director of the Bank of England. Parliament would set aside a million pounds sterling to invest at interest and build up the principal by reinvesting the dividends annually. In a surprisingly short period of time, Price promised, the fund would grow large enough to enable the government to extricate itself from its entire debt. “A state need never, therefore, be under any difficulties, for, with the smallest savings, it may, in as little time as its interest can require, pay off the largest debts.”
What Price had discovered was how the exponential growth of money invested at interest multiplies the principal by plowing back the dividends into new saving. Balances snowball in the hands of bankers, bondholders and other savers, as if there always will be enough opportunities to find remunerative projects and credit-worthy borrowers to pay the interest that is accruing.
The moral is that the economy’s ability to produce and earn enough of a surplus to pay exponentially rising interest charges is limited. The more it is stripped to pay creditors, the less able it is to produce and pay as a result of unemployment, underutilization of resources, emigration and capital flight.
In the two thousand years since the birth of Christ, the European economy has grown at a compound annual rate of 0.2 percent, far lower than the level at which interest rates have stood. Yet financial fortunes have crashed again and again – in part because interest payments have absorbed the revenue that otherwise would have been available for new direct investment.
The inability of productive investment opportunities to keep pace with the expansion of credit is the Achilles heel of finance-based growth. How can compound interest be paid? Who will end up paying it? Who will receive it, and what will they do with it? If banks and a creditor class receive this money, will they spend it domestically to maintain balance, or will they drain the economy’s income stream and shift it abroad to new loan markets, leaving the economy strapped by the need to pay interest on the growing debt? If the state accrues this money, how will it recirculate it back into the economy?
“The Magic of Compound Interest” vs. The Economy’s Ability to Pay
1. Neither money nor credit is a factor of production. Debtors do the work to pay their creditors. This means that interest is not a “return to a factor of production.” Little credit is used to expand production or capital investment. Most is to transfer asset ownership.
2. If loan proceeds are not used to make gains sufficient to pay the creditor (productive credit), then interest and principal must be paid out of the debtor’s other income or asset sales. Such lending is predatory.
3. The aim of predatory lending in much of the world is to obtain labor to work off debts (debt peonage), to foreclose on the land of debtors, and in modern times to force debt-strapped governments to privatize natural resources and public infrastructure.
4. Most inheritance consists of financial claims on the economy at large. In antiquity, foreclosure for non-payment was the major lever to pry land away from traditional tenure rights inheritable within the family. (Early creditors got themselves adopted as Number One sons.) Today, most financial claims are on the land’s rent, leaving ownership “democratized” – on credit.
5. Most interest-bearing debt always has been predatory, apart from lending for commerce. Carrying a rising debt overhead slows material investment and economic growth.
6. The rate of interest never has reflected the rate of profit, the rise in physical productivity or the borrower’s ability to pay. The earliest interest rates were set simply for ease in mathematical calculation: 1/60 per month in Mesopotamia, 1/10 annually in Greece, and 1/12 in Rome. (These were all the unit fractions in their respective fractional systems.) In modern times the rate of interest has been set mainly to stabilize the balance of payments and hence exchange rates. Since 2008 it has been set low to re-inflate asset prices and bank profits.
7. Any rate of interest implies a doubling time for money lent out. See the Rule of 72 (e.g., five years in Mesopotamia).
8. Modern creditors avert public cancellation of debts (and making banks a public utility) by pretending that lending provides mutual benefit in which the borrower gains – consumer goods now rather than later, or money to run a business or buy an asset that earns enough to pay back the creditor with interest and still leave a profit for the debtor.
9. This scenario of productive lending does not typify the banking system as a whole. Instead of serving the economy’s production trends, the financial sector (as presently organized) makes the economy top-heavy, by transferring assets and income into the hands of an increasingly hereditary creditor class.
10. The exponential growth of debt shrinks markets and slows and investment, reducing the economy’s ability to pay debts, while increasing the debt/output and debt/income ratios.
11. The rising volume of debt changes the distribution of property ownership unless public authorities intervene to cancel debts and reverse expropriations. In antiquity, royal “Jubilee” proclamations liberated bondservants and restored lands that had been foreclosed.
12. Cancelling debts was politically easiest when governments or public institutions (temples, palaces or civic authorities) were the major creditors, because they were cancelling debts owed to themselves. This is an argument for why governments should be the main suppliers of money and credit as a public utility.
Financial vs. industrial dynamics – and the One Percent vs. the 99 Percent
European and North American public debts appeared to be on their way to being paid off during the relatively war-free century of 1815-1914. The economy’s debt burden seemed likely to be self-amortizing by being linked to industrial capital formation. Bond markets mainly financed railroads and canals (the largest ventures usually being the most corrupt), mining and construction. Wall Street was interested in industry mainly to organize it into trusts and monopolies. Yet most economic writers limited their focus to the promise of rising technology and productivity, assuming that finance and banking would be absorbed into the industrial dynamic.
The threat of interest-bearing claims growing so exponentially as to subvert industrial progress was analyzed mainly by critics from outside the mainstream, many of whom were socialists. Two of the earliest books warning that financial dynamics threatened an economic crisis were published by the Chicago co-operative Charles H. Kerr, best known for publishing Marx’s Capital and Gustavus Myers’ History of the Great American Fortunes. In 1895, J. W. Bennett warned of a rentier caste drawing the world’s wealth into its hands as the inventive powers of industry were outrun by the mathematics of compound interest, “the principle which asserts that a dollar will grow into two dollars in a number of years, and keep on multiplying until it represents all of the wealth on earth.”
Although not much noticed at the time, Bennett was one of the first to recognize that financial recycling of interest receipts into new lending was the driving force of the business cycle. Despite the rising role of industry, “financial systems are founded on rent and interest-taking,” and “interest-bearing wealth increases in a ratio which is ever growing more and more rapid,” leaving few assets unattached by debt. The exponential growth of debt makes business conditions more risky, because “there are not available assets to meet [creditor] demands and at the same time keep business moving.” Bankers call in their loans, causing a crash followed by “a trade depression every ten years or oftener and panics every twenty years.”
The mathematics of compound interest explain “the extremely rapid accumulation of wealth in the hands of a comparatively few non-producers,” as well as “the abject poverty of a large percentage of the producing masses.” Non-producers receive “much the largest salaries,” despite the fact that their “income is often in inverse ratio to the service which [they do for their] fellow men.” As a result, Bennett concluded: “The financial group becomes rich more rapidly than the nation at large; and national increase in wealth may not mean prosperity of the producing masses.” All this sounds remarkably modern. The same basic criticisms were made after the 2008 crash, as if the discovery of predatory finance was something new.
Bennett’s contemporary John Brown (not the abolitionist) argued that compound interest “is the subtle principle which makes wealth parasitic in the body of industry – the potent influence which takes from the weak and gives to the strong; which makes the rich richer and the poor poorer; which builds palaces for the idle and hovels for the diligent.” Only the wealthy are able to save up significant amounts and let sums simply accumulate and accrue interest over time. Small savers must live off their savings, drawing them down long before the mathematics of compound interest become truly significant.
What is remarkable is that this principle of compound interest has come to be viewed as a way to make populations richer rather than poorer. It is as if workers can ride the exponential growth of financial debt claims, by saving in mutual funds or investing in pension funds to financialize the economy. This rosy scenario assumes that the increase in debt does not dry up the growth in markets, investment and employment in much the way that Ricardo imagined landlords and their rent would stifle industrial capitalism.
[W]hat Smith and Marx shared, critically, was the belief that it was entirely possible for an activity to be revenue- and profit-generative without actually contributing to the creation of value. There was no paradox. (Or rather, for Marx at any rate, the paradox was not that banks made profits without producing value, but that industrial capitalists allowed them to do so.)
J. P. Morgan and John D. Rockefeller are said to have called the principle of compound interest the Eighth Wonder of the World. For them it meant concentrating financial fortunes in the hands of an emerging oligarchy indebting the economy to itself at an exponential rate. This has been the key factor in polarizing the distribution of wealth and political power in societies that do not take steps to cope with this dynamic.
The problem lies in the way that savings and credit are lent out to become other peoples’ debts without actually helping them earn the money to pay them off. To the financial sector this poses a banking problem: how to prevent losses to creditors when loan defaults occur. Such defaults prevent banks from paying their depositors and bondholders until they can foreclose on the collateral pledged by debtors and sell it off. But for the economy at large, the problem is bank credit and other loans loading the economy down with more and more debt, “crowding out” spending on current output. Something has to give – meaning that either creditors or debtors must lose.
Politicians thus face a choice of whether to save banks and bondholders or the economy. Do they simply reward their major campaign contributors by giving banks enough central bank or taxpayer money to compensate losses on bad loans? Or do they restructure debts downward, imposing losses on large bank depositors, bondholders and other creditors by writing down bad debts so as to keep debt-strapped families solvent and in possession of their homes?
It is politically convenient in today’s world to solve the banking dimension of this problem in ways that please the financial sector. After the 1907 crash hit the United States harder than most economies, the Federal Reserve was founded in 1913 to provide public back-up credit in times of crisis. The assumption was that debt problems were merely about short-term liquidity for basically solvent loans whose carrying charges were temporarily interrupted by crop failures or a major industrial bankruptcy.
The exponential growth of debt was not anticipated to reach a magnitude that would bring economic growth to a halt. That worry has faded almost entirely from mainstream discussion for the past century.
The 1929-31 financial crash, of course, led the Yale economist and progressive Irving Fisher to analyze debt deflation (reviewed below in Chapter 11) and Keynes to urge government spending to ensure enough market demand to maintain full employment. In 1933 the New Deal created federal deposit insurance up to specific limits (rising to $100,000 before the 2008 crash, and $250,000 right after it, in order to stop bank runs). Banks paid a levy to the Federal Deposit Insurance Corporation (FDIC) to build up a fund to reimburse depositors of institutions that failed. The low fees reflected an assumption that such failures would be rare. There was no thought that the biggest banks would act in a reckless and unregulated manner.
The Glass Steagall Act, also passed in 1933, separated normal banking from the risky speculation until 1999, when its provisions were gutted under Bill Clinton. Banks were regulated to make loans to borrowers who could provide sound collateral and earn enough to carry their debts.
On paper, it seemed that the business cycle’s ebb and flow would not derail the long-term rise in income and asset values. Adopting Wesley Clair Mitchell’s theory of “automatic stabilizers” popularized in his 1913 Business Cycles, the National Bureau of Economic Research assumed that crises would automatically bring revival. The economy was idealized as rising and falling fairly smoothly around a steady upward trend.
The mathematics of compound interest should have alerted regulators to the need “to take away the punch bowl just as the party gets going,” as McChesney Martin, long-term Federal Reserve Chairman (1951-70) famously quipped. But the combination of New Deal reforms and soporific economic theory (assuming that economies could carry a rising debt burden ad infinitum) led regulators to lower their guard against the strains created by banks and bondholders lending on increasingly risky terms at rising debt/income and debt/asset ratios.
Alan Greenspan promised the public before the 2008 crash that a real estate implosion was impossible because such a decline would be only local in scope, not economy-wide. But by this time the pro-Wall Street drive by the Clinton Administration’s orchestrated by Treasury Secretary Robert Rubin (later to chair Citibank, which became the most reckless player) had opened the floodgates that led rapidly to widespread insolvency. Nearly ten million homes fell into foreclosure between 2008 and mid-2014 according to Moody’s Analytics. Cities and states found themselves so indebted that they had to start selling off their infrastructure to Wall Street managers who turned roads, sewer systems and other basic needs into predatory monopolies.
Across the board, the U.S. and European economies were “loaned up” and could not sustain living standards and public spending programs simply by borrowing more. Repayment time had arrived. That meant foreclosures and distress sales. That is the grim condition that the financial sector historically has sought as its backup plan. For creditors, debt produces not only interest, but property ownership as well, by indebting their prey.
The debt buildup from one financial cycle to the next
The business cycle is basically essentially a financial cycle. Its “recovery” phase is relatively debt-free, to the extent that a preceding crash has wiped out debt (and thus the savings of creditors), while prices for real estate and stocks have fallen back to affordable levels. This was the stage in which the U.S. economy found itself when World War II ended in 1945. The economy was able to grow rapidly without much private sector debt.
New homebuyers were able to sign up for 30-year self-amortizing mortgages. Bankers looked at their income to calculate whether they could afford to pay each month to pay up to 25 percent of their wages each month to pay off (“amortize”) the mortgage over the course of their working life. At the end of thirty years, they would be able to retire debt-free and endow their children with a middle-class life.
Wages and profits rose steadily from 1945 to the late 1970s. So did savings. Banks lent them to fund new construction, as well as to bid up prices for housing already in place. This recycling of savings plus new bank credit into mortgage lending obliged homebuyers to borrow more as interest rates rose for 35 years, from 1945 to 1980. The result was an exponential growth of debt to buy housing, automobiles and consumer durables.
Financial wealth – what the economy owes bankers and bondholders – increases the volume of debt claims from one business cycle to the next. Each business recovery since World War II has started with a higher debt level. Adding one cyclical buildup on top of another is the financial equivalent of driving a car with the brake pedal pressed tighter and tighter to the floor, slowing the speed – or like carrying an increasingly heavy burden uphill. The economic brake or burden is debt service. The more this debt service rises, the slower markets can grow, as debtors are left with less to spend on goods and services because they must pay a rising portion of income to banks and bondholders.
Markets shrink and a rising proportion of debtors default. New lending stops, and debtors must start repaying their creditors. This is the debt deflation stage in which business upswings culminate.
By the mid-1970s entire countries were reaching this point. New York City nearly went bankrupt. Other cities could not raise their traditional source of tax revenue, the property tax, without forcing mortgage defaults. Even the U.S. Government had to raise interest rates to stabilize the dollar’s exchange rate and slow the economy in the face of foreign military spending and the inflationary pressures it was fueling at home.
Deterioration of loan quality to interest-only loans and “Ponzi” lending
Hyman Minsky has described the first stage of the financial cycle as the period in which borrowers are able to pay interest and amortization. In the second stage, loans no longer are self-amortizing. Borrowers can only afford to pay the interest charges. In the third stage they cannot even afford to pay the interest. They have to borrow to avoid default. In effect, the interest is simply added onto the debt, compounding it.
Default would have obliged banks to write down the value of their loans. To avoid “negative equity” in their loan portfolio, bankers made new loans to enable Third World governments to pay the interest due each year on their foreign debts. That is how Brazil, Mexico, Argentina and other Latin American countries got by until 1982, when Mexico dropped the “debt bomb” by announcing that it could not pay its creditors.
Leading up to the 2008 financial crash, the U.S. real estate market had entered the critical stage where banks were lending homeowners the interest as “equity loans.” Housing prices had risen so high that many families could not afford to pay down their debts. To make the loans work “on paper,” real estate brokers and their banks crafted mortgages that automatically added the interest onto the debt, typically up to 120 percent of the property’s purchase price. Bank credit thus played the role of enticing new subscribers into Ponzi schemes and chain letters.
Over-lending kept the economy from defaulting until 2008. Many credit-card holders were unable to pay down their balances, and could only pay the interest due each month by signing up for new credit cards to stay current on the old ones.
That is why Minsky called this desperate third stage of the financial cycle the Ponzi stage. Its dynamic is that of a chain letter. Early players (or homebuyers) are promised high returns. These are paid out of the proceeds from more and more new players joining the scheme, e.g., by new homebuyers taking out ever-rising mortgage loans to buy out existing owners. The newcomers hope that returns on their investment (like a chain letter) can keep on expanding ad infinitum. But the scheme inevitably collapses when the inflow of new players dries up or banks stop feeding the scheme.
Alan Greenspan was assisted by the mass media in popularizing an illusion that the financial sector had found a self-sustaining dynamic for the exponential growth of debt by inflating asset prices exponentially. The economy sought to inflate its way out of debt through asset price inflation sponsored by the Federal Reserve. Higher prices for the houses being borrowed against seemed to justify the process, without much thought about how debts could be paid by actually earning wages or profits.
Banks created new credit on their keyboards, while the Federal Reserve facilitated the scheme by sustaining the exponential rise in bank loans (without anyone having to save and deposit the money). However, this credit was not invested to increase the economy’s productive powers. Instead, it saved borrowers from default by inflating property prices – while loading down property, companies and personal incomes with debt.
The fact that price gains for real estate are taxed at a much lower rate than wages or profits attracted speculators to ride the inflationary wave as lending standards were loosened, fostering lower down payments, zero-interest loans and outright fictitious “no documentation” income statements, forthrightly called “liars’ loans” by Wall Street.
But property prices were bound to crash without roots in the “real” economy. Rental incomes failed to support the debt service that was owed, inaugurating a “fourth” phase of the financial cycle: defaults and foreclosures transferring property to creditors. On the global plane, this kind of asset transfer occurred after Mexico announced its insolvency in 1982. Sovereign governments were bailed out on the condition that they submit to U.S. and IMF pressure to sell off public assets to private investors.
Every major debt upswing leads to such transfers. These are the logical consequence of the dynamics of compound interest.
Table B.100 from the Federal Reserve’s flow-of-funds statistics shows the consequences of U.S. debt pyramiding. By 2005, for the first time in recent history, Americans in the aggregate held less than half the market value of their homes free of debt. Bank mortgage claims accounted for more than half. By 2008 the ratio of home equity ownership to mortgage debt had fallen to just 40 percent.
Bank mortgages now exceed homeowners’ equity, which fell below 40% in 2011.
What happens when the exponential buildup of debt ends
During the financial upswing the financial sector receives interest and capital gains. In the fallback period after the crisis, the economy’s private- and public-sector assets are expropriated to pay the debts that remain in place.
A “Minsky moment” erupts at the point when creditors realize that the game is over, run for the exits and call in their loans. The 2008 crash stopped bank lending for mortgages, credit cards and nearly all other lending except for U.S. government-guaranteed student loans. Instead of receiving an infusion of new bank credit to break even, households had to start paying it back. Repayment time arrived.
This “saving by paying down debt” interrupts the exponential growth of liquid savings and debt. But that does not slow the financial sector’s dominance over the rest of the economy. Such “intermediate periods” are free-for-alls in which the more powerful rentiers increase their power by acquiring property from distressed parties. Financial emergencies usually suspend government protection of the economy at large, as unpopular economic measures are said to be necessary to “adjust” and restore “normalcy” – finance-talk for a rollback of public regulatory constraints on finance. “Technocrats” are placed in control to oversee the redistribution of wealth and income from “weak” hands to strong under austerity conditions.
This aftermath of the bubble’s bursting is not really “normalcy” at all, of course. The financial sector simply changes gears. As debt deflation squeezed homeowners after 2008, for instance, banks innovated a new financial “product” called reverse mortgages. Retirees and other homeowners signed agreements with banks or insurance companies to receive a given annuity payment each month, based on the owner’s expected lifetime. The annuity was charged against the homeowner’s equity as pre-payment for taking possession upon the owner-debtor’s death.
The banks or insurance companies ended up with the property, not the children of the debtors. (In some cases the husband died and the wife received an eviction notice, on the ground that her name was not on the ownership deed.) The moral is that what is inherited in today’s financialized economy is creditor power, not widespread home ownership. So we are brought back to the fact that compound interest does not merely increase the flow of income to the rentier One Percent, but also transfers property into its hands.
Financialization at the economy’s expense
The buildup of debt should have alerted business cycle analysts to the fact that as debt grows steadily from one cycle to the next, economies veer out of balance as revenue is diverted to pay bankers and bondholders instead of to expand business.
Yet this has not discouraged economists from projecting national income or GDP as growing at a steady trend rate year after year, assuming that productivity growth will continue to raise wage levels and enable thrifty individuals to save enough to retire in affluence. The “magic” of compound interest is held to raise the value of savings as if there are no consequences to increasing debt on the other side of the balance sheet. The internal contradiction in this approach is the “fallacy of composition.” Pension funds have long assumed that they and other savers can make money financially without inflicting adverse effects on the economy at large.
Until recently most U.S. pension funds assumed that they could make returns of 8.5 percent annually, doubling in less than seven years, quadrupling in 13 years and so forth. This happy assumption suggested that state and local pension funds, corporate pension funds and labor union pension funds would be able to pay retirees with only minimal new contributions. The projected rates of return were much faster than the economy’s growth. Pension funds imagined that they could grow simply by increasing the value of financial claims on a shrinking economy by extracting a rise in interest, dividends and amortization.
This theory simply wrapped Richard Price’s “sinking fund” idea in a new guise. It is as if savings can keep accruing interest and make capital gains without shrinking the economy. But a rate of financial growth that exceeds the economy’s ability to produce a surplus must be predatory over time. Financialization intrudes into the economy, imposing austerity and ultimately forcing defaults by siphoning off the circular flow between producers and consumers.
To the extent that new bank loans find their counterpart in debtors’ ability to pay in today’s bubble economies, they do so by inflating asset prices. Gains are not made by producing or earning more, but by borrowing to buy assets whose prices are rising, being inflated by credit created on looser, less responsible terms.
Today’s self-multiplying debt overhead absorbs profits, rents, personal income and tax revenue in a process whose mathematics is much like that of environmental pollution. Evolutionary biologist Edward O. Wilson demonstrates how impossible it is for growth to proceed at exponential rates without encountering a limit. He cites “the arithmetical riddle of the lily pond. A lily pod is placed in a pond. Each day thereafter the pod and then all its descendants double. On the thirtieth day the pond is covered completely by lily pods, which can grow no more.” He then asks: “On which day was the pond half full and half empty? The twenty-ninth day,” that is, one day before the half the pond’s lilies double for the final time, stifling its surface. The end to exponential growth thus comes quickly.
The problem is that the pond’s overgrowth of vegetation is not productive growth. It is weeds, choking off the oxygen needed by the fish and other life below the surface. This situation is analogous to debt siphoning off the economic surplus and even the basic needs of an economy for investment to replenish its capital and to maintain basic needs. Financial rentiers float on top of the economy, stifling life below.
Financial managers do not encourage understanding of such mathematics for the public at large (or even in academia), but they are observant enough to recognize that the global economy is now hurtling toward this pre-crash “last day.” That is why they are taking their money and running to the safety of government bonds. Even though U.S. Treasury bills yield less than 1 percent, the government can always simply print the money. The tragedy of our times is that it is willing to do so only to preserve the value of assets, not to revive employment or restore real economic growth.
Today’s creditors are using their gains not to lend to increase production, but to “cash out” their financial gains and buy more assets. The most lucrative assets are land and rent-yielding opportunities in natural resources and infrastructure monopolies to extract land rent, natural resource rent and monopoly rent.
The inability of economies to sustain compound interest and a rising rentier overhead for any prolonged time is at the root of today’s political fight. At issue is whose interests must be sacrificed in the face of the incompatibility between financial and “real” economic expansion paths. Finance has converted its economic power into the political power to reverse the classical drive to tax away property rent, monopoly rent and financial income, and to keep potential rent-extracting infrastructure in the public domain. Today’s financial dynamics are leading back to shift the tax burden onto labor and industry while banks and bondholders have obtained bailouts instead of debts being written down.
This is the political dimension of the mathematics of compound interest. It is the pro-rentier policy that the French Physiocrats and British liberals sought to reverse by clearing away the legacy of European feudalism.
Swiss solutions:
http://desiebenthal.blogspot.com/2009/01/stop-or-set-aside-by-eric-v-encina.html
Swiss solutions:
http://desiebenthal.blogspot.com/2009/01/stop-or-set-aside-by-eric-v-encina.html
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