Analysis by Keith Rankin.
In New Zealand, both Labour and National want the teaching of ‘financial literacy’ to become compulsory in schools. (See Labour pledges compulsory financial literacy classes in schools and National also aiming to make financial literacy compulsory in schools from One News, 20 August 2023. On the 6pm news, Prime Minister Chris Hipkins explicitly mentioned “compound interest”.)
The politicians should be careful what they wish for. Financial literacy, as understood by its advocates, has many of the elements of a scam. In the fantasies if the finance industry, the favoured many or few accumulate money at exponential rates, at the expense of the payers of interest. The one depends on the other; interest is a zero-sum game.
Mercantilism is to economics what astrology is to astronomy and alchemy is to chemistry. They are pseudo-sciences, albeit precursors to these modern sciences. The discipline of Finance remains deeply rooted in the pseudo-science of mercantilism. (We may note that George Soros’ most famous book is titled ‘The Alchemy of Finance’.)
Few economists know anything about mercantilism, just as few astronomers have knowledge of astrology, and few chemists know much about alchemy. The people who do know (or should know) about these harbingers of science are the historians of economics, astronomy, and chemistry. (Such historians are becoming increasingly scarce, as mentioned to me by an Australian friend who is a semi-retired senior academic, specialising in the history of economics. Disciplinary history courses have been culled, even in top universities such as the ANU, in part because of a lack of student demand, but also because higher education today is seen by the technocrats as little more than training for specific technocratic careers.)
‘Classical’ mercantilism conceives of nation-states as economic territories whose purpose is simply to ‘make money’; in particular it focuses on policies favouring trade surpluses, meaning exports exceeding imports. The underlying issue is the veneration, indeed the deification, of money; the perception that conflates ‘money’ with ‘wealth’, leading to the false conclusion that money serves more as a store of wealth than as a medium of exchange. (Properly trained economists understand that money is a ‘social technology’ which derives its utility from circulation rather than stasis.) From this mercantilist perspective, money should only be spent if such spending (‘investment’) yields even more money; money becomes an instrument for making money. Under mercantilism, we ‘live to make money’ rather than ‘make money to live’.
The Myth of Compound Interest
The ‘miracle’ of compound interest generally features early in any educational course on financial literacy; the myth of compound interest is a core proposition of ‘financial literacy’ dogma. (We note that a ‘myth’ is not the same as a ‘lie’. Rather a myth is a compelling ‘story’, or parable, which often contains some contextual truth.)
The ‘miracle’ is that of exponential growth, and is predicated on the idea that an above-zero risk-free rate of return on money-in-the-bank is an entitlement that amounts to a human right. The zealots who most promote this believe that there should be a right to a positive real rate of interest, risk-free; meaning that the entitled rate of interest should always be above the rate of inflation (ie not simply above zero).
The two most famous promoters of the myth, in history, were Benjamin Franklin (American founding father) and Albert Einstein (a scientific wizard, though not a financial wizard). Franklin apparently said “Money makes money. And the money that money makes, makes money”. Einstein reputedly said that “those who understand it, earn it and those who don’t, will pay it”. At least Einstein recognised that interest is paid by somebody, and not the ‘free money’ which the quote from Franklin suggests. What Einstein did not appreciate was that, if the average interest rate on bank deposits is below the average rate of inflation, then in fact those who ‘understand it’ lose, and it is those who don’t understand it get something for nothing. Further, at least in the history of the twentieth century (and also Franklin’s eighteenth century; though not so much the nineteenth century) bank deposit interest rates have generally been below inflation rates.
If we look at the year 1936 (when there was a census of incomes), the equivalent to today’s minimum wage would have been $100 per year. If that sum was saved in the bank in 1936, today it would have compounded to $7,000 if the after-tax interest yield had been 5% every year. That would be a break-even on our usual measure of inflation. But the minimum wage for a person working 40-hours per week today is $47,000. $7,000 would be regarded today as a very poor return on the substantial sum (to a wage-worker) of $100 (£50) in 1936.
However, if the $100 could have been invested in 1936 at 10% risk-free after tax (more like 12% before tax) for 87 years, the compounded nest-egg today would be $400,000. That’s what the miracle of compound interest is about. The reality, though, is that a compounding risk-free yield of 10% per year for 87 years would have been a fantasy. Even an interest yield of 5% every year for 87 years would have been unrealistic.
For another example, the average salary in 1973 – fifty years ago – was about $4,000. Today it’s more like $70,000. Further, based on the Reserve Bank’s inflation calculator, $4,000 in 1973 is equivalent to $59,481 in 2023. Wages have increased more quickly than prices in the last 50 years; though both rates of increase are similar: wages have increased by about 5.9% a year, whereas prices have increased on average by 5.547% each year. So, for compound interest to increase the value of a term deposit faster than the rate of wage increases, then the average interest rate would have had to be over six percent after tax. To have got a miraculous return from compound interest, the bank deposit interest rate before tax would need to have been more than ten percent every year. Unrealistic.
Given the now known inflation rate, money saved in the bank for those 50 years at five percent every year before tax would have resulted in a 50% depreciation of what that money could buy. That’s a more realistic outcome of safe saving. The reality of the past 50 years is that savers have lost, and borrowers have gained. For the most part, compound interest has come at a high opportunity cost. In-control debt would have yielded more happiness.
The proper context of saving
Can financial literacy education be useful, especially the promotion of thrift, despite the falsity of the compound interest miracle? Yes, because some people can fund their needs and wants without spending their entire salaries. For those people, the ‘present utility’ (ie enjoyment) from spending not-needed money is quite low; so, by saving for a day when they will need extra money, then the saved money will come in handy, even if it has depreciated in value in the meantime.
The reality, however, is that a large portion of peoples’ savings ends up in their estates when they die. They never spend it. Indeed, for many, saving money is a form of insurance, and not a plan to consume less when they are young and more when they are old. If the ‘insurance’ is not required, the money is passed onto the next generation, or in other forms of bequest.
So, an important question to raise is: What should a youngish person do if they receive a lump-sum of money in a will, or a lottery. My analysis suggests that they are better off spending it than trying to save-and-compound it. Though, the ‘present utility’ of spending the windfall all at once would be low. A financially literate person would spend the money over a period of time. Specialist insurance products probably make more sense than using compound interest as a form of alternative insurance; although, like the quest for compound interest, many people get a low return on their insurance premiums. Much insurance costs too much.
The proper and improper context of investing
Investing is the process of risk-taking; of risk, and hoped-for reward. Some people who think that an above-inflation rate of return is a right (or a reward for abstinence) rather than a gambling reward will end up taking naive risks. This situation will be less likely in the event of well-structured financial literacy education. This is the proper context.
Unfortunately, people who already have much – often too much – have had the financial power to gain near-certain rewards through processes of speculation (often disguised as ‘investing’) and otherwise taking advantage of people who have too little. The most prominent of these situations is the use of market-power to make money from trading in real-estate; ie trading in land. This kind of ‘investment’ for high returns substantially undermines the housing market.
Any worthwhile financial literacy education would need to properly deal with the issues of land use and land speculation. Yet my sense is that the financial literacy curriculum in New Zealand will end up pushing people to use KiwiSaver as an opaque means to promote both compound interest and real estate speculation. Many people who rent or buy their homes for exorbitant market prices are also themselves property speculators, because such speculation drives up returns in their higher-yield-strategy KiwiSaver accounts. KiwiSaver yields derived from land speculation come at a high cost to people trying to make a home for themselves and their families.
Back to Mercantilism
The rhetoric of KiwiSaver – and other savings’ products – is that of using money to make money. The reality is that the over-purchase of ‘financial products’ makes high profits for the finance industry. This is the mercantilist mirage – even ‘scam’ – at the heart of industrial finance. It’s the modern version of the pot of gold at the end of the rainbow. Mercantilism is the cult of money, not the science of money.
Real compound interest is economically unsustainable; and requires an exorbitant demand for debt, the flipside of bank deposit interest. It represents a monetary transfer from the vulnerable to the privileged, from the needy to the greedy. People like Roger Douglas in the 1980s tried to create a revolution in New Zealand underpinned by real compound interest. They have achieved both unsustainable inequality, and also much resourcefulness by ordinary people trying to live their best indebted lives.
It is a patrician fantasy to create a global economic system whereby the poor perpetually pay real compound interest to the rich. For capitalism to survive, interest rates need to be less than or equal to inflation rates. Under those conditions, debt doesn’t look so bad and unproductive saving doesn’t look so good. Indeed, if somehow ordinary people are able to shun debt, then interest rates must fall far too low to generate real compound interest. Ultimately, interest rates are set in the marketplace, not by the authorities.
Keith Rankin (keith at rankin dot nz), trained as an economic historian, is a retired lecturer in Economics and Statistics. He lives in Auckland, New Zealand.