I’m teaching exponential relationships to my class tomorrow morning and one of the applications of this understanding is obviously debt.
We just got finished discussing linear relationships last week, and it got me thinking: why is the accumulation of interest not linear? You’ve only borrowed the principal, so in my mind, if you’re going to have interest, it would be proportional to the amount of the principal you haven’t paid off yet.
Thinking like a lib (or maybe not since I can’t understand the way it actually works), the lender would be unable to access a certain amount of money that they previously did have access to, and thus would be privy to a proportion of that amount. As you pay on the principal, that amount should go down because they have more access to the money they previously had access to.
What purpose does your interest creating more interest serve other than simply to siphon money from the ones that need to borrow and those that have enough to lend?
Obviously that is the reason, but I’m just curious if there’s an actual reason they have, or if they really are just that blatant.
I think it will help to see money as a relation, rather than a static thing. Then I’ll give some examples. I’m no expert but I think working through some examples will be helpful.
If I had $1000 in my bank today, I could buy $1000 worth of stuff today. In a year’s time, I could maybe buy $900 worth of stuff, because prices are going up. Meaning, $1000 might still be called $1000 and look like the same $1000. If it were under my mattress, it may even be the same 20x$50 notes. But it isn’t the same $1000; what I can use it for depends on a wide range of factors, including inflation. The number in the account may be static, but the number only means something as a relation.
If I lend you that $1000 at 3% for one year, you pay me $1000 plus $30. By the time you pay me, prices have gone up. You’ve only really paid me back $900+$30 worth of stuff (‘ish’, because the $30 isn’t worth as much, either).
I could charge simple interest at the rate of inflation and break even, more-or-less. But what if you take two years to pay? Do I charge compound interest at 10%/year or (if my maths are correct) simple interest at 21%/biennially? Do I adjust the simple figure if you pay me back early?
Compound interest seems to be a more straightforward way of working out how much the borrower needs to repay to actually repay what was borrowed (relationally, i.e. what the money can buy) rather than the initial sum (e.g. the static $1000). You only actually pay interest on interest if you borrow too much and can’t pay off more than the yearly addition. People don’t always have a choice, of course, house prices being what they are, for example.
When you borrow money from a bank as a loan, you get both figures. Or an approximation (because interest rates fluctuate and debtors can make overpayments). Consider a mortgage. You get e.g. the ‘5.7%/year (compound)’ and you get a typical estimate of the overall interest, e.g. $75,000 on a mortgage of $100,000 if you take 35 years to repay.
Not everyone who borrows that money will actually repay the $75,000. You could borrow the $100,000 at 75% but then you risk losing out if the base rate or inflation go down or if you get a pay rise that would let you make overpayments.
Compound interest can work in the borrower’s favour as well as the lender’s. It’s perhaps easier to see with commercial loans, where the borrower and lender have more equal bargaining power. Maybe the borrower has more bargaining power. Compound interest is not always ‘unfair’ in a straightforward way.
Compound interest is monstruous, don’t get me wrong, and compound interest is a factor in prices going up, but it has a certain logic to it. As for the bourgeois rationale, it’s going to be something like the above but without the words ‘relational’ and ‘static’.
The reason for using compound interest is that the economy moves exponentially rather than linearly. Well, the shape is actually an s-curve, but standards tend to be set on the basis of the initial exponential part rather than the slowing down part.
Since population, especially in an early capitalist economy grows exponentially, the labor-value of the capital stock also does. The growth of capital stock represents the growth of wealth for capitalists, so when they give out loans, they do so against a baseline comparison of exponential capital stock growth.
Whenever it comes to capitalist economies, you should always start your thinking with population and its growth. That tends to be a key determiner of long-term capitalist dynamics.
I’m not sure if this answer provides a root explanation for the question, but in a competitive (but not prestigious) undergrad business program the answer provides is https://en.m.wikipedia.org/wiki/Time_value_of_money
Interest paid is offered as compensation for the opportunity cost the lender experiences by lending rather than immediately spending. I still don’t see why this implies compound interest, except that vaguely the opportunity cost increases faster than the passage of time.
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Personal failure
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Simplicity of tracking the balance owed
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Compound interest is more powerful than simple interest, so of course we use it for everything
I see the personal failure one used more often and in multiple forms. “Pay off your debt each month and your credit card won’t charge interest,” or “If you didn’t understand the terms of the loan, you shouldn’t have signed it/read the fine print.”
I don’t know why certain types of loans use simple interest instead of compound interest other than as an alluring alternative that is often offered after someone is already trapped in a cycle of credit card debt. Since there is a period before simple and compound interest meet, I assume they have calculated that profits will be higher for simple interest in that case, but it could just be marketing after someone was burned by compound interest.
An important point I noticed in the third paragraph of your question that you didn’t explicitly ask about is the difference between bank finances vs personal finances. Access to money for banks is far different than for individuals. This may be too much for your students, but you may find it interesting. I definitely will not be able to explain all of this sufficiently:
Banks do not need to keep enough money on-hand to pay off all of their debts at once. There is a set minimum they must keep. Everything else gets invested/leveraged elsewhere, including the debts that are owed to them. This is something individuals can also do to manipulate interest in their favor (to a lesser extent), but banks are also insured by the state and in some ways operate as issuers of the states money. This last part is explained within modern monetary theory and allows them to do fucky things with money.
When you have access to what are essentially unlimited streams of money, the rules for borrowing and lending don’t affect you the same as when your financial streams are limited.
There is a set minimum they must keep.
This is fractional reserve banking / money multiplier, and turns out to be a myth: https://www.youtube.com/watch?v=cDNSNX48Kmo
in some ways operate as issuers of the states money.
I’ve never heard of private banks doing this; they certainly don’t in the US. That’s what central (i.e. state) banks or, in the case of the US, the Treasury do.
The most succinct MMT explainer I’ve found so far for is JT’s: Why The Government Has Infinite Money. The show notes on further resources are excellent.
On fractional reserve banking, thank you, I wasn’t aware.
And on MMT, again, thank you for providing more sources. I didn’t want to type up a long post on this, so my comment was VERY generalized.
JT’s video was good, but there are plenty of more in-depth sources around. I believe it was either RevLeft or Guerilla History that had some of the academics who came up with this theory on their show sometime in the last year as well, which are a good listen.
I honestly don’t think that MMT holds up to scrutiny. It seems like a charming theory, but it only works when applied to the US dollar. If any other country decided to simply print money to fund their government budget, they’d quickly run into hyperinflation. The US gets away with it (for now) due to their extraordinary privilege of having the hegemonic global reserve currency.
As I have understood it, private banks are also involved in money creation, as the interest they charge on loans is considered “new money.” Then again, not even liberal academics can fully explain how money is created (within their ideological boundaries of course). They have some ideas, but nobody commits to defining it.
It seems like a charming theory, but it only works when applied to the US dollar. If any other country decided to simply print money to fund their government budget, they’d quickly run into hyperinflation.
This is not true at all. Hyperinflation is very rare and only happens under specific, known conditions. It’s quite avoidable, except if you’re a small country that the US is trying to regime change (in which case all bets are off anyway).
PEGS Institute: What Caused Hyperinflation In Weimar, Zimbabwe And Venezuela?
It’s not like the US is unique in having fiat monetary sovereignty. AFAIK every country that has monetary sovereignty today is using a fiat money. Here’s a copypasta from a comment of mine on a post about China’s economy:
[George Soros] later admitted in 2001, that the local monetary authorities did a good job in preventing the collapse of the Hong Kong market. The precise way that China avoided this speculatory attack was through its strict state-set capital controls and its state-owned financial system
To use the metric of return on assets (ROA) and liquidity ratios to measure the effectiveness of China’s state-owned banking system is ultimately meaningless. This is because Chinese banks take on the means primarily resembling development banks. In turn, this system has an overall positive impact in the long term, despite not having the myopic short termism of Western commercial profit-oriented banks. This is due to the ability of long-term funding at low interest rates being key for the sake of large-scale infrastructure construction, which in turn is vital for long term economic development.
The reason why China’s economy is able to be stable and avoid the damages of the Great Financial Crisis of 2008 and the COVID Crisis of 2020 was precisely because it was able to draw up large amounts of State investment to offset the decline in private investment.
MMT isn’t a politics and isn’t prescriptive. It’s simply descriptive of fiat monetary sovereignty. Many liberal proponents and detractors alike seem to want to load up MMT with all sorts of things that it isn’t. It certainly isn’t going to solve all of capitalism’s internal contradictions under a dictatorship of the bourgeoisie. But China seems to be showcasing its veracity.
As I have understood it, private banks are also involved in money creation, as the interest they charge on loans is considered “new money.”
That doesn’t make any sense. The interest I owe on my loan is the opposite of money: it’s a hole I’m obligated to fill with money. It means I have to acquire money from somewhere, somehow to pay that interest or else default on my loan. In this sense, private banks are a drain on the economy. The neoliberal financialization of the US and other countries is creating debt deflation. Michael Hudson’s Killing the Host is about (PDF).
I hadn’t even considered the difference between bank and personal finance. Thank you for you well thought out response, Comrade.
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it’s something that can be traced since Babylonia. Michael Hudson has a book specifically about this subject, the collapse of antiquity i think. I haven’t read it tho but i remember him promoting the book once in a ben norton podcast.
IMO it adds pressure to pay the loan, a simple interest does not generate pressure. in typical fashion, banks pay bondholders simple interest (depends), but they charge compound interests on their loans.
I haven’t read them yet either, but that was the first book in the trilogy he’s writing, …and forgive them their debts. The second book, The Collapse of Antiquity, is about how antiquity’s wisdom of debt forgiveness was dispensed with.
It describes how the dynamics of interest-bearing debt led to the rise of rentier oligarchies in classical Greece and Rome. This caused economic polarization, widespread austerity, revolts, wars and ultimately the collapse of Rome into serfdom and feudalism. That collapse bequeathed to the subsequent Western civilization a pro-creditor legal philosophy that has led to today’s creditor oligarchies.
He’s working on the third book now, about the middle ages.
“Compound interest pleases the Economy.”
That is an interesting question. It is taken as an axiom so I never even questioned it until now.
Since money-lending is a practice with long history, I wonder if interest always was compound or if it was linear before a certain period of time.
I imagine it depended on region, but FWIW interest was not even always a given (all three major Abrahamic religions historically/textually prohibited it, in Judaism’s case however only among fellow Jews). Debt forgiveness, something seen as unimaginable to modern western societies, also were a occasional thing in history- ancient Jewish society in particular having the debt “jubilee” (the origin of the word jubilee), or in many other societies, it happening in an infrequent manner to quell peasant revolts.
From what I recall in investment class in college it’s all about risk vs reward. If you don’t provide enough reward with the compounding interest then no one would be silly enough to take on the risk of loaning the money because it would take too long to get a worthwhile return.
But fuck the system tbh. Life shouldn’t be about accumulating the most, it should be about everyone living well together.
