Ban Compound Interest to Save the Planet?

by Kenneth Anderson

Ordinarily I do not blog on articles or discussions that seem to me entirely muddle-headed; life is too short.  However.

(Admittedly irritating digression:  Life is particularly too short here at the Hoover Institution, Stanford, where I am spending a few weeks finishing a book manuscript on US-UN relations in the next administration, whosever it happens to be.  The weather in Palo Alto is a flawless 78 degrees at midday, low humidity, radiant blue sky and the promise of a blissful sunset; so far as I can tell, no one can ever be unhappy here, especially as the Hoover Institution folks take darn good care of its visiting scholars.  And yet … people are amazingly productive here, once acclimatized to the fact that, yes, tomorrow will be another day in paradise.  Don’t take my word for it – ask Jim Goldgeier, who by complete accident also happens to be here and have the office next to mine for a few weeks.  Hoover is a much more eclectic place than people know – Obama advisor Michael McFaul is down the hall, for example.  But the Hoover Institution being historically a bastion of economists … also, one of my particular interests, as a professor of international business and finance, is to draw more international economics and finance into our beloved Opinio Juris, which I hope will not drive everyone completely crazy because it is not traditional public international law:)

John-Paul Flintoff writes in this Green Central column of the Sunday Times (London) of July 23, 2008, that compound interest should be banned in the interests of both global economic development and the global environment.  His word, not mine; he is unequivocal about it.  His argument proceeds elliptically; he points out that third world debt, unpaid, has multiplied at compound interest to absurd levels.  He cites as authority a scholar on Islamic finance, for the view that the glories of Muslim Spain and the regions thereabout flourished without the payment of interest.  He says that, after all, 

doing without money that was lent at interest didn’t stop our predecessors trading, or building incredible monuments, from Westminster Abbey to the colleges of Oxford and Cambridge.

Let me do my best Megan McArdle impression and just observe about that quoted assertion: Oxford and Cambridge and Westminster are incredible monuments in large part because that’s all that is left from the period.  It’s all they could afford.  Without systems of finance, and particularly compound interest, to discount and spread the costs of long term and long serving capital construction across generations, one would build only to the extent that one could claw the pennies from the groaning peasantry of each generation.  The occasional Westminster, but not Manhattan.  Compound interest is an essential ingredient in the Industrial Revolution take-off that, for the first time in human history, carried human societies beyond the near-Malthusian equilibrium, as economic historian Gregory Clark’s new book, A Farewell to Alms, reveals in depressing detail over the whole of human history.  

Taken as a whole system, compound interest is a mechanism for making long term investment in society not just more efficient, but generationally vastly more equitable.  But don’t take the word of a Hoover fellow for it – talk to Cass Sunstein.  Generational discounting – which is to say compound interest – is the most important feature of generational equity, as Cass Sunstein explains with exceptional clarity in his second last book (or third?), Worst Case Scenarios.

But apart from Flintoff’s article, there is an interesting side observation to make about sovereign debt historically.  One of the most fascinating – and quite ignored – books on the history of finance and political economy is James Macdonald, A Free Nation Deep in Debt: The Financial Roots of Democracy (Princeton UP 2006; it came out earlier in the UK, I think.)  Macdonald, an investment banker turned finance historian (a little like Peter Bernstein, author of Against the Gods: The Remarkable Story of Risk), examines the political economy of European sovereign debt and debt markets beginning with early modernity.  The title alone is compelling – from an anonymous 18th century philosophe pamphlet arguing that the best way of preventing despotism is to have the King indebted to his own citizens – freedom for the citizenry because the King owes them money.  

Of course, that requires a robust Parliament to represent those interests and prevent the King from repudiating the debts.  But in England it worked; the ‘consol’ form of the gilt market in British sovereign debt (perpetual annuities) has been around in one form or another since the eighteenth century.  In France, a different story entirely.  Who would have imagined the Memoirs of the Duc de Saint-Simon, the famously chatty diary-account of the court of the Sun King, would contain a lengthy passage (lament, really) arguing that France could never finally win a war against England precisely because of its absolute monarchy: the Kings of France, having the complete liberty and, worse, the known propensity to repudiate debts, would always have to borrow money for campaigns at a vastly higher interest rate than the English crown.  Since – Macdonald provides historical evidence to bear this out – kingdoms of the period could never manage to finance more than the first couple of campaigns out of the existing treasury, war depended upon finance, and the fortunes of war in no small part on the interest rate paid.  

Moreover, although arguments against “usury” are often cited (correctly) to, for example, the Church, in fact in many cases in that period, the crown was the driving force behind ecclesiastical pressures against usury, which is to say, another form of medieval and early modern European persecution of the Jews.  The threat of the Inquisition, in earlier periods in Spain, for example, having had at times a remarkable lowering effect on the interest rate.  (I read Macdonald’s book, as it happens, while on sabbatical in Seville, at the gym located on the ancient Calle de la Inquisicion.

***

My underlying reason for raising this article, however, is not merely in order to nominate Flintoff’s column for possibly least economically literate article in the mainstream press this year.  (I also apologize for my rather flippant tone if anyone finds it offensive.)  It is, rather, that I have this law professor concern that were I to assign this to my business law students – IBT, for example – and ask them to evaluate the arguments, strengths and weaknesses, agree or disagree, a sizable percentage of them would be unable to say (regardless of whether they agreed or not) what the weaknesses of the argument are; they could presumably parrot back its strengths.  The number of law students (at my school at least) who are economically literate at the basic level has gone up a lot since I first started teaching in the 1990s, and I think it has gone up drastically at the top level schools ever since they fell out of love with humanities and in love with social statistics – but I would say these days at the mid-tier schools it is a double humped curve – the students who have done some economics know a lot more about the real world of finance and business than they did a decade ago, but there is a big hump of students that don’t know much at all.  

What I don’t really understand about that group of students, however, is that when I do surveys in class and ask how much economics students have taken, virtually every student has at least taken two semesters as a survey course.  But although they describe themselves as having learned to draw some graphs, they do not appear to have been taught how to connect it to the real world, or to develop a form of reason in an “economics” kind of way – incentives, supply and demand, etc.  

Those students often self-select out of courses in business law that might require that they develop some skills that direction – not, in my experience, because they don’t want such skills, but because, in an environment of steep grade inflation, they (rationally) think they cannot afford even a B+ in a course in which they are not already quite sure of getting an A or A-.  Which goes to show, I suppose, that they think like economists after all. I don’t know what to do about this; I am very interested in pedagogical suggestions for courses like IBT.

http://opiniojuris.org/2008/07/26/ban-compound-interest-to-save-the-planet/

13 Responses

  1. After tutoring economics at a college for over a year, I have to agree that most students can not connect what they learn to the real world. This is caused in part by the professors. Many of the professors are excellent statisticians and fully understand numbers and their relations, but when it comes to psychology they have no clue.
     
    Economics is primarily a psychological problem; you have to understand people and their motives BEFORE you can accurately describe them with numbers. In today’s academia there is a huge disconnect, we are trying to describe in numbers behavior we don’t understand.
     
    Until the psychological part of the “dismal science” is put back in, we will continue to fail our students and the future.
     

  2. I’m not really sure that they had compound interest in the middle ages.  It’s much more likely that they had simple interest instead, as all municipal bonds used to be. (Remember clipping coupons?  They were the interest earned for that half-year on the underlying principal.  You never had interest on interest for munis back then.)

    But you are exactly right in that capital formation in the middle ages was a huge problem, and held civilization back for hundreds of years.

  3. Of all mankind the great poet is the equable man.WaltWhitmanWalt Whitman, Leaves of Grass, 1855

  4. I have a better suggestion for Flintoff: why not ban the enforceability of contracts? That way, we can pretty much bring civilization to a standstill. And it’s civilization that is responsible for ecological disaster, right?

    Rex: Any simple interest loan is equivalent to some compound-interest loan — it’s just at a different nominal interest rate. Put another way, any stream of cash flows can be equated to a present value, given a (compound-interest) discount rate. The compound rate that is equivalent to a given simple interest rate is the one which gives the same present value as the loan amount. So banning compound interest loans in favor of simple interest  loans would have absolutely no effect, unless you simultaneously ban HP-12 calculators and spreadsheets ;-)

    BBB

  5. Isn’t his other major historical error his statement that the Muslim world got along without interest?  A cursory look at the long established forms of Islamic finance shows this to be completely untrue – Muslim finance levies interest in all but name.  The automatic parroting of “west bad Islam good” betrays his political aims with this piece of nonsense too.

  6. The devil’s agents may be of flesh and blood, may they not?SirArthurConanDoyleSir Arthur Conan Doyle, The Hound of the Baskervilles

  7. Response…
    Flintoff on Islamic finance is even worse than you mention:  Any close examination of Islamic financial institutions will show one moderately knowledgeable about banking and finance that they are covertly funded by interest bearing or synthetically interest bearing instruments.

  8. “It’s much more likely that they had simple interest instead, as all municipal bonds used to be. (Remember clipping coupons?”

    If you pay the interest as it comes due, there is nothing to compound.  Your example hardly denies the practice of compounding interest.

  9. KA: “Flintoff’s column [is] possibly least economically literate article in the mainstream press this year.”

    Is it that Flintoff’s illiterate, or is it that, like many eggheads in Europe, he is trying on some Islamic ideas?  “How does this fit?  Does it go with these shoes?  Does this make me look fat?”

    He’s eager to surrender and submit to Islam, so he’s trying it on first, seeing how it goes with his other Lefty duds, like Gaia-worship and anti-capitalism.  Don’t think “Econ 101.”  Think “pre-Dhimm.”

    (BTW, I sympathize re Palo Alto.  The key is to remind yourself that tomorrow will be just as lovely as today.)

  10. As pointed out, simple interest is a system that exchanges simplicity of calculating nice round dollar and cents amounts (no messy powers needed in the pre-calculator age) for complexity/opacity of the actual compound interest rate being charged.

    A $1000 bond, selling at par and promising 6% interest today, pays $30 every six months, but it is economically equivalent today to a bond promising $60.90 every year.   The “actual” interest rate, 6.09% per year, is simply hidden in favor of the dollar interest coupon amounts being “simple”.  

    Another simplifying tradeoff is used in the T-Bill market where the “banker’s discount” quoting convention is applied in a formula allocating the “interest” evenly over the number of days to maturity.   With a modern calculator it is trivial to compute the “bond-equivalent” yield that correctly accounts for compounding.

    From 1969 to 1982 even the IRS messed up by using “simple” interest to calculate how much a corporation could deduct for imputed interest on its zero coupon bonds.   By treating the accrual of value as evenly divided over the life of the bonds, they allowed zero issuers to take massively overvalued interest deductions.   With interests low in the 1970’s it didn’t really matter much, but with long treasuries in double digit yields by 1982 the tax-arbitrage was on in earnest…  Needless to say they corrected that mistake for future issues as quickly as bureaucracy would allow, but the mistake has lived on for old bonds, detailed in IRS Publication 1212.

  11. Single-minded, sweeping general changes are just f**king stupid! CHANGE, and limit compound interest laws, Re-write the laws on incorporation, adding responsibilities to the environment and humanity, Without capital we can do little, without investors, we have no capital, without incentives we have no investors! We need capitalists but we must limit their actions to prevent rogue, whore, gotcha, savage, soulless, profit maximizing, sociopathic, predator and parasitic capitalism. Laws need to be brought up to date or changed. The problems are in the laws and lawyers that support sickness in their own communities for a bribe sized – fee!  The courts need cleansing, the judges need purifying and the people need educating. End of Rant

  12. Here’s an article on <a href=”http://www.contingencies.org/janfeb05/0105takaful.pdf”>takaful</a>, the Islamic insurance methodology, also designed to get around proscriptions on interest.

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