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Wednesday, May 21, 2008

The Compound Interest Paradox - a Simpler Explanation

A lot of people have asked for a short and simple explanation of the Compound Interest Paradox. I'm planning an updated version my Compound Interest Paradox post, scheduled to be posted in a few weeks. (Now that Blogger offers "scheduled posting", I'm queuing up posts ahead of time. I have 3 months' worth of nearly finished drafts queued up, and I schedule posts a week in advance now.)

There's a fundamental structural flaw in debt-based money. Money is only created when someone takes out a loan. However, only the principal is created and not the interest payments. For example, suppose a bank borrows $1B from the Federal Reserve at 5% interest for 1 year, either directly at the Discount Rate or via the Federal Reserve "monetizing the debt". In a year, the bank must repay $1.05B. The $50M required interest was never created or put into circulation. Therefore, there's a permanent money supply shortfall. Everyone is enslaved under a crushing debt burden.

The key step in the money creation process is when banks borrow from the Federal Reserve to create new reserves. Only the Federal Reserve can create new money, and all the money it creates has debt strings are attached. For each $1 the Federal Reserve creates, the financial industry can create $9 more via fractional reserve banking. This new money is recycled. The interest payments on the extra $9 are recycled as bank profits and expenses. Banks always are "loaned up" to the full reserve ratio allowed by law. Surplus bank reserves are loaned to other banks, or (rarely) back to the Federal Reserve via reverse repurchase agreements. However, the interest payments on the $1 created by the Federal Reserve are *PERMANENTLY* destroyed as the loan is repaid. Total debt is always greater than total money.

When the Federal Reserve creates new money, the Compound Interest Paradox operates with the full force of law. The general public does not have the financial industry's money-printing power, and their access to money is always limited by the Compound Interest Paradox. Banks don't need to collude to cause economic booms and busts, because Fed Funds Rate changes force them to collude. Before the Federal Reserve was created, large banks colluded to create economic booms and busts. The usual "Problem! Reaction! Solution!" scam led to the creation of the Federal Reserve. It was State regulation of banking in the first place that allowed large banks to collude to cause economic cycles, which then allowed them to lobby for the creation of the Federal Reserve.

Consider a quantum mechanics analogy. In quantum mechanics, a proton and anti-proton can be simultaneously created. They later collide and are destroyed, for no net effect. Similarly, dollars and anti-dollars (debt) are always created in matching pairs. However, the anti-dollars multiply via interest, whereas the dollars do not. Therefore, when the dollars and anti-dollars collide and cancel, there always are surplus anti-dollars left over.

In the USA, monopolies are openly discussed as immoral. The Federal Reserve is the biggest monopoly of all. The Federal Reserve's monetary monopoly is more valuable than the monopoly of the State itself. By delegating its money-printing power to the Federal Reserve, the State has delegated most of its power to the Federal Reserve.

There are a lot of consequences of the Compound Interest Paradox.

  • Boom/bust cycles are not an economic law of nature. They are a consequence of an unfair monetary system. The people who control large corporations love this arrangement, because their smaller competitors are bankrupted during the bust phase; large corporations can withstand the cycle.
  • Boom/bust cycles encourage consolidation of industries. Large corporations are the most common business, because they can most effectively withstand boom/bust cycles and lobby the State for favors.
  • Real interest rates must be negative, to ensure any money is in circulation at all. Negative real interest rates provide a massive subsidy to the financial industry and large corporations, paid by everyone else as inflation. Banks and hedge funds can borrow the cheapest, followed by large corporations. Individuals cannot borrow on favorable terms, or cannot borrow at all.
  • Without a gold standard (sound money), individual savings are stolen by inflation.
  • Income taxes and regulations prevent people from boycotting the Federal Reserve and using sound money instead. If you develop an on-the-books alternate monetary system based on real money (gold or silver), the taxes and regulations make it impractical. Whenever someone works, Federal Reserve Points must be paid as taxes/tribute.
  • Negative real interest rates mean that the cheapest way to finance a business is via the financial industry/State. With fair market-determined rates, growing a business via reinvested earnings is comparable/preferable to borrowing. This places individuals on an equal footing with large corporations.
  • Individuals cannot easily accumulate capital to form their own businesses. Their savings are eroded by inflation. The stock market doesn't earn a positive inflation-adjusted return. Politically connected insiders can start businesses, because their connections allow them to get funding from the financial industry. In a communist society like the USA, connections are more important than talent.
  • Individuals cannot profitably loan each other money. If you loan money to your friends at 6%, that isn't keeping up with inflation. If you make a gold-denominated loan, that has an implied interest rate of 20%-30%; it would be cheaper to borrow from a bank.
  • Individuals don't have the magic money-printing power that banks have. This means that they will always be slaves of the bankers.
  • The financial industry has a unique perk. They get to print the money that everyone else uses to trade. This guarantees that the financial industry will *ALWAYS* be about 10% of the economy.
  • Large banks become "too big to fail". If one is forced into bankruptcy, then a bailout is *NECESSARY*, because otherwise the financial system starts to unravel. In a free market, one business' bankruptcy does not threaten the stability of its competitors, if they are prudently managed. There is no need for financial industry insiders to be concerned about negative consequences of bad decisions; there will *ALWAYS* be a Federal Reserve bailout, either directly as was the case with JP Morgan Chase and Bear Stearns, or indirectly in the form of a Fed Funds Rate cut.
  • With the ability to (literally) print money, the financial industry can lobby the State for perks. They can guarantee that reform will never occur. The insiders bought out all the TV stations and newspapers, guaranteeing their abuses will never be exposed. (The Internet is changing the equation somewhat. I predict that the Internet will enable an agorist revolution.) The financial industry insiders bought control of schools and universities, guaranteeing that only fake economics (Keynesian economics) and fake politics ("Taxation is not theft.") will be taught in schools. The financial industry insiders arranged for everyone else to be educated/brainwashed as slaves ("good citizens/consumers"). (Most politics courses don't even ask the question "Are taxes different from stealing?" It's an undiscussed axiom that taxes are morally acceptable.)
  • With negative real interest rates, the incentive is for banks and hedge funds to maximize their use of leverage, because this maximizes their profits. Only politically connected insiders can start a hedge fund. There is no true "free market" for hedge fund managers; they are merely a group of people highly skilled at lobbying the State for favors.
  • When inflation occurs, wealth is stolen from one group of people and transferred to another group of people, the people who print the new money and spend it first. Most new money is created by the financial industry, rather than by Federal deficit spending. Therefore, the primary beneficiary of money supply inflation is the financial industry insiders and not the government.
If this explanation is still too complicated, let me know. Once you understand the Compound Interest Paradox, a lot of economic problems are easier to understand. The Compound Interest Paradox is a key concept, and I agree that it should be my #1 most popular post by a wide margin.

I try to answer are serious reader questions. Pro-State trolls get annoying after awhile. Fortunately, most pro-State trolls get disgusted and leave. I'm continuing my policy of pointing out and ridiculing pro-State trolls.


Francois Tremblay said...

FSK- would you like to host the next Carnival? The one for June 29th.

Anonymous said...

Hey FSK, great post. When you broke into quantum mechanics I was like "oh lord" lol.However I actually did get the proton collision concept and how it ties into the inherent flaw of how the debt through interest, with fractional reserve banking helping as well, will always be greater than the money supply. I have always felt strongly that the monopolization of our economy was bad for everyone, and not even sound economics; based on fair principles anyway. I have concentrated on anti-trust law as a means to break up monopolization but while in theory that could be effective, I never factored in the CIP and the Federal Reserve system as the principle motivation for mergers. There are more conclusions that I have come to that were the result of reading this post and for that I am very grateful, but it's getting late here and I would be preaching to the choir elaborating on them with you anyway. One other though, right as I clicked on your article "beware of liberatarians as red market agents", not the exact wording but something like that, I remember thinking to myself before the page even loaded what pains in the rear some of the guys at the Luwig Von Mises institute are. Haha. When I was younger I first started reading some Rothbard stuff and was particularly fascinated by Mises' axioms, or at least attempts at establishing them, in the area of environmental stimuli in development and reactions in human behavior. Anyway, I thought I'd try engaging with some of the fellows over there and I could never get one viable or practical solution out of them in terms of addressing even one of the institutional flaws or inadequecies that they write about. On hand they claim to embrace Mises' conclusions about state interventionism in economics, subsidies, taxation, military force, etc.,. But on the other they would put some thin vail of criticism over the FED about how this or that chairman made a tactical mistake without ever addressing its systematic flaws, or even its right to exist. At first I thought they were just stupid or uninformed but it became apparent to me that they are pro-state, neo-con operators with I'm sure varying degrees of blind complicity or deliberation amongst them. Of course the geographical location of Alabama, my home state where I also currently reside, I would think would be a high-volume area for recruits given the educational disfunction that is rampant here. Ok so that was a long "one more thing", but I couldn't help but find both humor and a sense of validation in reading the article you wrote. Again great post, I have made a lot of progress since yesterday.


Inquisitor said...

Robert, I'm not sure who you are talking about - name names. I post quite frequently at the LVMI blogsite and I have yet to see anyone defend the Fed who is a contributor to the site or a regular poster. I'm wondering if we're even talking about the same LVMi...

Anonymous said...

I explained this to my 10 year old very simply. I pulled out 100 $1 bills and said "we're going to create a country and this will be all the money it will ever have. The only way to release this money is for it to be borrowed by the people from me, the banker. I will make one loan to you and you have to pay me back with interest. The total due will be $105. How are you going to pay me back?" It took him awhile, but he realized that he will never have the extra $5 since there will not be more money than the $100 set out initially. I then told him I could loan $200 so there would be enough to pay back the $105 but that the new loan would require $210 to pay back. Where was he going to get the money this time? Same answer. I told him this is how it works and the cycle repeats. He knows that if the lending stops, the country loses its possessions and also that the debt keeps adding up. He doesn't think it can keep doing this forever and will eventually fail.

Anonymous said...

Another flawed analysis, all the money to pay the interest is included in the original loan. The interest is paid up front. Your very first payment is 98% interest and 2% loan capital. The 2% returns to the blue sky money heaven from which the banks created it out of nothing more than your ability to repay the loan.

The OTHER 98% is the BANKSTERS profit that he spends back into the pool of money that is our monetary economy.

Through your labor over the next month you will earn enough from that pool of money to make your next payment and the bankster will then spend his cut of 97.8% back into that same pool of money.

A better system than the banksters debt-based money is the system our constitution mandates. A wealth based system of gold and silver coins. The current system of paper FRN's are a lie by no good thieves when they call them dollars.

A Dollar is a unit of weight of pure silver.

The “DOLLAR” (from daalder, dahler, thaler, an abbreviation of Joachimsthaler) was a piece of money first coined, about the
year 1518, in the valley of St. Joachim, in Bohemia, Germany.

In the US, its definition used to be:

(a) A silver coin of the United States containing 371.25 grains of silver and 41.25 grains of alloy having a total weight of
412.5 grains.

(b) A gold coin of the United States containing 23.22 grains of gold and 2.58 grains of alloy having a total weight of 25.8
grains, nine-tenths fine (one ounce is 480 grains, so this is about $20 per ounce).

These two coins had different names, dollars and eagles and were to be coined by the people at any US Mint from bullion. This money supply was controlled by the people and not by the government. If there were too many coins of a given metal and their price in terms of what bullion was fetching the people had the right to melt those coins and sell them as bullion and conversely if bullion was cheap, they could have the US mint make coins for a small mintage fee.

Anonymous said...

I should be more careful when I post. In the early 1900's the banksters sought to remove silver from the Dollar and define a Dollar in terms of gold. Then they could corner the market on gold and controll the monetary system, something they couldn't do with silver, because there is just too much lilver available.

Excerpt from Franklin Sanders:

On this day in 1792 the US congress
passed the Coinage Act, which (under
the Constitution's authority) forever
& immutably set the standard "dollar"
at 371.25 grains of fine silver. The Act
provide for no gold coins denominated
in "dollars", but only Eagles, Half Eagles,
and Quarter Eagles valued at $10, $5, &
$2.50, establishing a "symmetallic" &
not a bimetallic or monometallic standard.
The system was most astutely designed
to allow a permanent silver dollar coin
as the basis of the currency, with periodic
adjustments of the gold coinage to allow
for the change in the gold/silver ratio
value at market. This was actually done in
the 1830s without cheating a single member
of the public.

Anonymous said...

I suggest your read The Theory of Money and Credit by Ludwig Von Mises if you really want to understand Money, Credit, and Inflation.

Anonymous said...

I just cant understand how u could bring all that explanation on such fallacies. first of all u are considering only a single activity of money burrowing. U have neglected the time value of money, inflation and other economic interactions in ur analysis. If ur analysis were true then how come with over 100 years of invention of compound interest we are not under crushing debt ?? .

Francois Tremblay said...

Because the government keeps printing more money.

seanl said...

Interest paid to the FED is *not* taken out of circulation. It goes to pay its operating expenses and the remainder is returned to the Treasury. Only the principal is taken out of circulation.

Usually when you think you've discovered something simple and obvious that a lot of smart people seem to have missed, it's because you're missing something.

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