The Compound Interest Paradox
FSK's Guide to Reality (June 02 2007)
I made an updated series of posts on the Compound Interest Paradox. Some people complained this post is too complicated, and I made a simpler version.
By a wide margin, this is my most popular post. It's popular for a good reason. You don't understand the corrupt nature of the economic system until you understand the Compound Interest Paradox.
I've seen the following argument mentioned 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 six percent interest rate payable over thirty 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 was 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 discount rate. As you pay off your loan, money is removed from circulation. In practice, as you pay off your loan, that money will be used to issue other loans, or be paid out as the bank's expenses and profits. (Actually, the bank typically will sell your loan immediately so it isn't exposed to the risk that the short-term interest rate will change. That was the cause of the Savings & Loan crisis; banks were borrowing short-term from depositors but lending long-term to mortgages. When short-term interest rates spiked up due to inflation and the abandonment of the gold standard, the banks were stuck.)
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. But 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 risk-free rate of 5.25%, so they could loan it to you at six percent, 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.
That is why 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. That's because the banks were careful to make sure they control all the major media. After all, with all the money, it's very easy to buy up all the major media. Their control is hidden via trusts and preferred voting shares. Plus, any story critical of the banking industry really wouldn't be entertaining. It would be too complicated for the average person to understand and wouldn't attract advertisers. A TV station wouldn't want to lose the ads placed by banks.
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 six percent might be beneficial, if you can invest the proceeds at ten percent 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. Provided the bank had managed its risk effectively, the value of the confiscated assets, plus the loan repayments received, would be enough to stay in business and still profit.
If all outstanding loans were called in, would there be enough dollars in circulation to pay them all back simultaneously? I suspect the answer is no, but I couldn't find hard statistics. That's why the Federal Reserve is able to lower the money supply by increasing interest rates. As interest rates are raised, fewer new loans are issued. The net effect is that loans are called back and the amount of money in circulation decreases.
The Federal Reserve is able to force banks to collude and offer fewer loans, because the Federal Reserve controls interest rates. If the interest rate was so high that no new loans were offered at all, then banks would just invest their assets with the Federal Reserve at that rate, instead of investing by issuing loans.
Economic cycles are inevitable in an economy where money is only created by debt. Artificially low interest rates encourage borrowing. At some point, those loans need to be repaid and there's a temporary decrease in available money. During a recession or depression, loans are defaulted on and the banks take possession of real assets. That is the only time that total debt decreases, but even with these defaults, debt increases exponentially faster than the money supply.
In my "Discounted Cashflow Paradox" post, I made an argument that the value of a dollar is zero. If the supply of dollars in circulation is less than the sum of all outstanding loans, then 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.
I really need to look up this statistic - sum total of all outstanding loans and sum total of all dollars in circulation. I have no idea where to look, but I suspect that the sum of all dollars is far less than the sum of all loans. New loans need to keep being issued to prevent collapse.
For example, the accumulated federal deficit is larger than the current M2 money supply. How can the government be in debt by more money than actually is in circulation? That's kind of silly.
Of course, if there was an absolute bar on issuing new loans, it would soon be obvious to everyone what is happening. Instead, what happens is that the price of a loan is increased slightly. This means that marginal loans are not issued. There are now slightly fewer dollars in circulation, but not so much fewer that the entire scam is exposed. Only the people with the worst credit rating are forced into bankruptcy. Does this sound familiar? It's the current "sub-prime lending" problem.
The Federal Reserve doesn't say "Let's increase the wealth confiscation rate". Instead, they say "We are concerned about inflation and decreasing unemployment and we are increasing the short-term interest rates".
Why should the Federal Reserve be concerned about decreasing unemployment? Decreasing unemployment means that workers are starting to be able to demand higher salaries. Their standard of living is increasing. That means that there is more wealth available due to a more productive economy. That wealth needs to be confiscated. The easiest way to confiscate it is to take money out of circulation, forcing everyone who has a loan to have a harder time repaying it.
When the money supply starts getting too tight, the fed lowers interest rates. However, the average person does not get to borrow at the risk-free rate. The benefits of financial stimulation (lower rates) primarily go to financial industry insiders. The average person just sees inflation, especially if he has money in the bank instead of inflation-hedged investments.
Plus, the average person does not know in advance when interest rates are going to be raised or lowered. That makes it much riskier for the average person to take out a loan. An insider has the opportunity to profit immensely.
There needs to be continuous inflation or else the whole system will collapse. Inflation is needed to ensure there's enough new money to pay back all the loans. If everybody simultaneously refused to borrow money, the financial system would collapse. If a substantial percentage of people simultaneously refused to borrow money, everyone else would be forced into bankruptcy.
Another benefit of inflation is that the average person keeps his money in the bank, or has benefits such as a pension or social security. These payments are not properly adjusted for inflation. Inflation allows the financial industry and government to slowly confiscate these assets. That's why the government doesn't want to ever contract the money supply too much. If the money supply contracted too much there would be deflation and the average person, who is holding mostly cash, would benefit.
As long as the Federal Reserve keeps a balance, the average person won't get wise to the situation. As long as a certain number of new loans are made, the average person will have access to enough money to repay his debts. There will be some foreclosures and bankruptcies, but from the point of view of the average person, those people deserved it. They won't say "The financial system was stacked against them - a certain number people had to go bankrupt because there wasn't enough money in circulation".
Most of the people who are aware of the details of this scam are themselves billionaires already. Knowing the defect in the financial system, they are able to profit from it immensely. Plus, they are insiders who know in advance which way interest rates are going to be moved. It's easy to make money if you know that. They have no incentive to fix the current system, except for the possibility that it might completely collapse soon. Any billionaire who is aware of the system can profit immensely from it. Any billionaire who is not aware will soon lose his wealth. With an awareness of the manipulations of others, it is possible to structure your own investments to maximum advantage. The basic advice I would give the average person is to minimize debt and invest in concrete assets - stocks or real estate or your own business.
If the banks wound up obviously owning everything, the average person would revolt. Some of the assets are hidden in trusts, so the average person doesn't know about it. Most media companies are incorporated in a way that insiders effectively control the company, even though they own a minority interest, through the issue of preferred voting shares. The money supply and tax rate are carefully managed so that the average person gets to own enough so that they don't revolt.
The national debt is actually absolutely necessary under the current system. Money can only be created via debt, and debt increases exponentially faster than the supply of money. The only way that someone can have money is for someone else to be in debt by an even bigger amount. Since the government is the only entity that can have unlimited debt without being forced into bankruptcy, the government needs to have bigger and bigger debt just so that there would be a supply of money for other people to have.
Is there any escape from this system? I think there is, but it would take a massive coordinated effort. I'm worried that the government and media are too corrupt to be trusted to fix this problem. It's tricky, because any solution would have to be implemented without breaking any existing laws, which are specifically designed to prevent anyone from ending this system of abuse.
I thought about advocating a return to a barter system. That wouldn't work, because a person doing barter legally has to pay income taxes on the value of his transaction, and the only valid means for paying taxes is with dollars. Because the government demands that taxes be paid in dollars, that creates a certain demand for dollars. It's impossible to live legally without dollars, because you have to pay your taxes. Maybe that's why the income tax had to be implemented the same time as the Federal Reserve system was established. Without income taxes, a person could effectively boycott the Federal Reserve, only making enough transactions in dollars to pay their taxes and dealing in barter otherwise. Since barter transactions are taxed the same as dollar transactions, with taxes paid in dollars, there's no way to boycott the Federal Reserve system by returning to a barter system.
The only way to fix the monetary system is by changing the laws. There's no way for individuals to legally boycott the standard financial system, because they have to pay their taxes in dollars.
That's one thing that annoys me about the other "critics of the Federal Reserve" websites. They explain the problem, but they don't really propose a workable solution. I don't think there is a solution possible without getting enough grassroots support to change the laws.
http://fskrealityguide.blogspot.com/2007/06/compound-interest-paradox.html
Bill Totten http://www.ashisuto.co.jp/english/index.html
I made an updated series of posts on the Compound Interest Paradox. Some people complained this post is too complicated, and I made a simpler version.
By a wide margin, this is my most popular post. It's popular for a good reason. You don't understand the corrupt nature of the economic system until you understand the Compound Interest Paradox.
I've seen the following argument mentioned 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 six percent interest rate payable over thirty 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 was 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 discount rate. As you pay off your loan, money is removed from circulation. In practice, as you pay off your loan, that money will be used to issue other loans, or be paid out as the bank's expenses and profits. (Actually, the bank typically will sell your loan immediately so it isn't exposed to the risk that the short-term interest rate will change. That was the cause of the Savings & Loan crisis; banks were borrowing short-term from depositors but lending long-term to mortgages. When short-term interest rates spiked up due to inflation and the abandonment of the gold standard, the banks were stuck.)
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. But 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 risk-free rate of 5.25%, so they could loan it to you at six percent, 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.
That is why 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. That's because the banks were careful to make sure they control all the major media. After all, with all the money, it's very easy to buy up all the major media. Their control is hidden via trusts and preferred voting shares. Plus, any story critical of the banking industry really wouldn't be entertaining. It would be too complicated for the average person to understand and wouldn't attract advertisers. A TV station wouldn't want to lose the ads placed by banks.
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 six percent might be beneficial, if you can invest the proceeds at ten percent 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. Provided the bank had managed its risk effectively, the value of the confiscated assets, plus the loan repayments received, would be enough to stay in business and still profit.
If all outstanding loans were called in, would there be enough dollars in circulation to pay them all back simultaneously? I suspect the answer is no, but I couldn't find hard statistics. That's why the Federal Reserve is able to lower the money supply by increasing interest rates. As interest rates are raised, fewer new loans are issued. The net effect is that loans are called back and the amount of money in circulation decreases.
The Federal Reserve is able to force banks to collude and offer fewer loans, because the Federal Reserve controls interest rates. If the interest rate was so high that no new loans were offered at all, then banks would just invest their assets with the Federal Reserve at that rate, instead of investing by issuing loans.
Economic cycles are inevitable in an economy where money is only created by debt. Artificially low interest rates encourage borrowing. At some point, those loans need to be repaid and there's a temporary decrease in available money. During a recession or depression, loans are defaulted on and the banks take possession of real assets. That is the only time that total debt decreases, but even with these defaults, debt increases exponentially faster than the money supply.
In my "Discounted Cashflow Paradox" post, I made an argument that the value of a dollar is zero. If the supply of dollars in circulation is less than the sum of all outstanding loans, then 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.
I really need to look up this statistic - sum total of all outstanding loans and sum total of all dollars in circulation. I have no idea where to look, but I suspect that the sum of all dollars is far less than the sum of all loans. New loans need to keep being issued to prevent collapse.
For example, the accumulated federal deficit is larger than the current M2 money supply. How can the government be in debt by more money than actually is in circulation? That's kind of silly.
Of course, if there was an absolute bar on issuing new loans, it would soon be obvious to everyone what is happening. Instead, what happens is that the price of a loan is increased slightly. This means that marginal loans are not issued. There are now slightly fewer dollars in circulation, but not so much fewer that the entire scam is exposed. Only the people with the worst credit rating are forced into bankruptcy. Does this sound familiar? It's the current "sub-prime lending" problem.
The Federal Reserve doesn't say "Let's increase the wealth confiscation rate". Instead, they say "We are concerned about inflation and decreasing unemployment and we are increasing the short-term interest rates".
Why should the Federal Reserve be concerned about decreasing unemployment? Decreasing unemployment means that workers are starting to be able to demand higher salaries. Their standard of living is increasing. That means that there is more wealth available due to a more productive economy. That wealth needs to be confiscated. The easiest way to confiscate it is to take money out of circulation, forcing everyone who has a loan to have a harder time repaying it.
When the money supply starts getting too tight, the fed lowers interest rates. However, the average person does not get to borrow at the risk-free rate. The benefits of financial stimulation (lower rates) primarily go to financial industry insiders. The average person just sees inflation, especially if he has money in the bank instead of inflation-hedged investments.
Plus, the average person does not know in advance when interest rates are going to be raised or lowered. That makes it much riskier for the average person to take out a loan. An insider has the opportunity to profit immensely.
There needs to be continuous inflation or else the whole system will collapse. Inflation is needed to ensure there's enough new money to pay back all the loans. If everybody simultaneously refused to borrow money, the financial system would collapse. If a substantial percentage of people simultaneously refused to borrow money, everyone else would be forced into bankruptcy.
Another benefit of inflation is that the average person keeps his money in the bank, or has benefits such as a pension or social security. These payments are not properly adjusted for inflation. Inflation allows the financial industry and government to slowly confiscate these assets. That's why the government doesn't want to ever contract the money supply too much. If the money supply contracted too much there would be deflation and the average person, who is holding mostly cash, would benefit.
As long as the Federal Reserve keeps a balance, the average person won't get wise to the situation. As long as a certain number of new loans are made, the average person will have access to enough money to repay his debts. There will be some foreclosures and bankruptcies, but from the point of view of the average person, those people deserved it. They won't say "The financial system was stacked against them - a certain number people had to go bankrupt because there wasn't enough money in circulation".
Most of the people who are aware of the details of this scam are themselves billionaires already. Knowing the defect in the financial system, they are able to profit from it immensely. Plus, they are insiders who know in advance which way interest rates are going to be moved. It's easy to make money if you know that. They have no incentive to fix the current system, except for the possibility that it might completely collapse soon. Any billionaire who is aware of the system can profit immensely from it. Any billionaire who is not aware will soon lose his wealth. With an awareness of the manipulations of others, it is possible to structure your own investments to maximum advantage. The basic advice I would give the average person is to minimize debt and invest in concrete assets - stocks or real estate or your own business.
If the banks wound up obviously owning everything, the average person would revolt. Some of the assets are hidden in trusts, so the average person doesn't know about it. Most media companies are incorporated in a way that insiders effectively control the company, even though they own a minority interest, through the issue of preferred voting shares. The money supply and tax rate are carefully managed so that the average person gets to own enough so that they don't revolt.
The national debt is actually absolutely necessary under the current system. Money can only be created via debt, and debt increases exponentially faster than the supply of money. The only way that someone can have money is for someone else to be in debt by an even bigger amount. Since the government is the only entity that can have unlimited debt without being forced into bankruptcy, the government needs to have bigger and bigger debt just so that there would be a supply of money for other people to have.
Is there any escape from this system? I think there is, but it would take a massive coordinated effort. I'm worried that the government and media are too corrupt to be trusted to fix this problem. It's tricky, because any solution would have to be implemented without breaking any existing laws, which are specifically designed to prevent anyone from ending this system of abuse.
I thought about advocating a return to a barter system. That wouldn't work, because a person doing barter legally has to pay income taxes on the value of his transaction, and the only valid means for paying taxes is with dollars. Because the government demands that taxes be paid in dollars, that creates a certain demand for dollars. It's impossible to live legally without dollars, because you have to pay your taxes. Maybe that's why the income tax had to be implemented the same time as the Federal Reserve system was established. Without income taxes, a person could effectively boycott the Federal Reserve, only making enough transactions in dollars to pay their taxes and dealing in barter otherwise. Since barter transactions are taxed the same as dollar transactions, with taxes paid in dollars, there's no way to boycott the Federal Reserve system by returning to a barter system.
The only way to fix the monetary system is by changing the laws. There's no way for individuals to legally boycott the standard financial system, because they have to pay their taxes in dollars.
That's one thing that annoys me about the other "critics of the Federal Reserve" websites. They explain the problem, but they don't really propose a workable solution. I don't think there is a solution possible without getting enough grassroots support to change the laws.
http://fskrealityguide.blogspot.com/2007/06/compound-interest-paradox.html
Bill Totten http://www.ashisuto.co.jp/english/index.html
posted by Bill Totten at
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