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Tuesday, June 3, 2008

The Compound Interest Paradox Revisited - Overview

Since my original post on the Compound Interest Paradox, I have a lot more to write about. This article is broken up into a series.

Table of Contents

The Federal Reserve
Free Market Banking
A List of Monetary Systems
Edward Flaherty is a Troll

According to Google Analytics, the Compound Interest Paradox is my #1 all-time most popular post. In the blogosphere, posts older than a few days don't attract attention. I'm publishing an updated version of this post on the one year anniversary of the original. I'm better at explaining since writing my original post. I have a lot more material about the Compound Interest Paradox than when I wrote the original, so I'm breaking this up into several posts.

The Compound Interest Paradox and the Voting Scam are the two key arguments against the current economic and political system. The Compound Interest Paradox explains the fundamental defect in the US monetary system. The Voting Scam explains why this problem cannot be fixed by voting or by any elected politician.

When I first wrote about the Compound Interest Paradox, I hadn't discovered agorism. I hadn't yet come to the conclusion that agorism/anarchism is the only morally defensible political philosophy.

Some other blogs and websites are referring to the Compound Interest Paradox by name, citing me as the source.

There's a book called "The Debt Virus" by Jacques S. Jaikaran, which I didn't hear about until after my post on the Compound Interest Paradox. "The Compound Interest Paradox" is a better name than "The Debt Virus". I haven't read "The Debt Virus". I only read resources that are available for free on the Internet.

I'm starting to see the Compound Interest Paradox mentioned by name on other websites. This idea is commonly discussed, but apparently I was the first person to directly name it. It is kind of amazing that making up a phrase like "the Compound Interest Paradox" can be so powerful. Plus, my explanation of the Compound Interest Paradox is simpler than the other explanations. I wasn't even sure I had made up the name "Compound Interest Paradox", but other people are giving me credit for inventing it.

Some people have complained that my explanations are too complicated. If you have any specific questions, let me know. I recently wrote a simplified version of my Compound Interest Paradox post.

The following argument is on many "critics of the Federal Reserve" pages. It confused me immensely until I finally figured it out. The argument is that in a financial system like the one in the United States, where money is created via debt, the only outcome can be that the banks will eventually own everything. The problem is that, in the course of repaying a loan, the sum amount of payments always exceeds the amount of the loan. The net effect of a loan is to decrease the amount of money in circulation. Since money can only be put into circulation via a loan, the system guarantees that the banks will eventually own practically everything.

Suppose you buy a house for $350,000. You make a $50,000 downpayment and take out a loan for $300,000 at a fixed 6% interest rate payable over 30 years. Your total payments over the lifetime of the loan (assuming you don't repay it early), will be $647,514.

What is the effect of this loan on the money supply? When you take out the loan, the money supply increased by $300,000. Either the bank loaned you money that was already on deposit, or it borrowed the money from the Federal Reserve at the Fed Funds Rate. In either case, $300,000 of new money was created. As you pay off your loan, money is removed from circulation. In practice, as you pay off your loan, other new loans are issued to other people so that the money supply is continually increasing.

The net effect of your loan, viewed in isolation, is that the total money supply has DECREASED by $347,514. You collected $300,000 and repaid $647,514. Fortunately for you, between the time you received your loan and when you repaid it, the bank was also issuing other loans to other people. Enough extra money was printed so that you could repay your loan.

But where does that $347,514 go? It goes to the financial industry. They are receiving the money in the future, when it will be worth less than it is now. Some of that money is paid out as profits and salaries and expenses. What effort did the bank spend to create the $300,000 it gave you? The answer is: no effort at all. It was just a bookkeeping entry. They may have borrowed the money from the Federal Reserve at the Fed Funds Rate of 2%, so they could loan it to you at 6%, but the Federal Reserve ultimately just printed the money it lent to the bank. The bank had sufficient collateral, its assets and other deposits (and now your mortgage).

In such a system, the banks will eventually own everything. The only way for new money to be created is by a loan, and money lent out is always less than money repaid. Total debt can only increase exponentially over time.

Newspapers and television are never critical of the banking industry. You will never see a major newspaper or TV show criticize the fundamental structure of our financial system. The bankers were careful to make sure they control all the major media. With all the money, it's very easy to buy up everything. Their control is hidden via trusts and preferred voting shares.

However, the banks don't own absolutely everything. A careful person can minimize his use of debt, and eventually build up a reasonable amount of investments. Plus, debt at a rate of only 6% might be beneficial, if you can invest the proceeds at 10% or more. It's only possible to do this because other people are making loans as well. If you knew that the loan you took out would be the last one ever issued, you would never be able to repay it.

Each loan has the effect of decreasing the number of dollars in circulation, because the payments always are more than the principal. What would happen if all the banks got together and said "let's collude and offer no more new loans"? As loans were repaid, there would be fewer and fewer dollars in circulation. Prices would drop. Some people would be unable to pay off their loans. The banks would foreclose, taking possession of real assets, even though the dollars they loaned out cost nothing to print. Then, the banks can get together and say "let's start issuing loans again". This causes inflation and the confiscated assets can be sold as a profit.

Banks don't need to get together and collude. The Federal Reserve forces banks to collude to create boom/bust cycles. Before the Federal Reserve was created, large banks had to collude to create boom/bust cycles. By changing the Fed Funds Rate, the Federal Reserve forces banks to collude to create boom/bust cycles.

Under the current USA monetary system, the Compound Interest Paradox operates with the full force of law. The Federal Reserve has a monopoly over money creation, and the Federal Reserve only creates money by issuing loans. The Federal Reserve only creates the principal; the Federal Reserve never creates the required interest payments.

Taxes and regulations prevent people from using alternate monetary systems. Anyone who sets up an alternate monetary system is usually guilty of tax evasion or "facilitating money laundering". The income tax and the IRS prevent people from boycotting the Federal Reserve, because income taxes MUST be paid in Federal Reserve Points.

In my "Discounted Cashflow Paradox" post, I pointed out that the long-run value of a dollar is zero, even if those dollars are invested "safely" in Treasury bonds. If the supply of dollars in circulation is less than the sum of all outstanding loans, the the value of a dollar is not zero, it's imaginary! I mean imaginary in the strict Mathematical sense. If there's no way that all outstanding loans could be simultaneously repaid, then the supply of dollars will always be less than the total demand. If you solve the equations, you get (I suspect), an imaginary number. In practice, this does not occur, because new loans are always being issued.

Even worse, I recently concluded that stocks may not earn a positive inflation-adjusted return, if you use the price of gold as your index of inflation.

The Purchasing Power Shortfall

Due to the Compound Interest Paradox and negative real interest rates, the productive capacity of the economy is *ALWAYS* greater than the aggregate purchasing power.

Negative real interest rates provide a massive subsidy to large manufacturers. The money required to buy these products is not also created. During the boom phase, extra factories are built. People assume the boom phase will last forever.

During the bust phase, there isn't enough money in circulation to purchase all the manufactured goods. Small manufacturers are forced into bankruptcy. Large manufacturers have an advantage due to their size. They are able to weather the bust phase and start expanding again during the next boom phase.

The Compound Interest Paradox is responsible for boom/bust cycles. The economy must oscillate between a boom and a bust. Economic cycles aren't an "economic law of nature". They're a direct consequence of a corrupt monetary system.

1 comment:

eagledove9 said...

Your explanations aren't "too complicated." They're not complicated enough. I didn't understand a word you were saying until you used a quantum physics analogy and talked about dollars and anti-dollars. Then it all made sense. I'm serious!

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