Like Cavemen Discovering Fire

Earlier today I had the chance to witness something very entertaining, and that is the glories of @pmt, or the function that one uses to calculate payments and compound interest. There were four people involved. Two of them were young people whose behavior demonstrates them to be immensely financially ignorant. More on that shortly. The other two of us were more savvy and mature people, one of whom has a great deal of experience in running imaginary banks and companies and serves as a mentor to one of the people. The venue was the Potato Company’s discord, and what we were witness to was a discovery akin to that of cavemen discovering fire, as these two financial newbies discovered how much profit could be made at loaning money to others at compound interest. Immediately, visions of conjuring money from nothing danced in their heads, and they sought to charge each other and others with compound interest and pushing them into default to increase their profits from debt. Despite the fact that people like myself have for some time and with considerable effort have been trying to convince them that their borrowing was a bad idea, their discovery of the math behind it clued them in on just how bad of an idea it was, and urged them onward to creating a bank by which they could snare others in compound interest’s grasp just as they had been snared themselves, with no sense of mercy.

It is easy to laugh at children seeking to exploit compound interest even as they find themselves trapped within it. It is less easy to laugh at us when we are beset by the same problems. It is bad enough when we have to wrestle with college loans and credit cards that we are gradually trying to pay off to give ourselves a bit of a cushion. It is far worse when someone is trying to deal with payday loans or debt peonage. The essential nature of compound interest and what makes it so threatening is that it involves the time value of money. People with short-term thinking tend to value what they have now to a great degree and have a high discounting rate on what happens in the future so that it matters little or nothing to them what may happen tomorrow or next year. In contrast, those with long-term thinking are continually thinking about their current behavior as an investment in a better future, and thinking about how a little today can be turned into a lot next year. As my young acquaintances have found out, a common way of profiting off of compound interest is to profit off of the impatience of other people, although it is wise when we know ourselves to recognize that we are not immune from such exploitation ourselves.

A common illustration of the power of compound interest involves the worth of New York City. In the 1660’s, England and the Dutch Republic were involved in one of a series of wars, and during that war the Dutch traded Suriname for New York. To most contemporary Americans, this seems like a ridiculous deal. Suriname is a small country of about 500,000 residents with an average income somewhere around China and South Africa, while New York City is a thriving if unpleasant metropolis of massive size, wealth, and cultural self-importance. Yet the miracle of compound interest lets us know that the value of New York City when compared to Suriname was not the slam dunk for the English empire that many assume. The Dutch purchased Manhattan island for the rough equivalent in wampum for $24.00 or so, 1624 dollars, admittedly, but $24 nonetheless. Setting aside the question of whether this was or was not paid to the wrong tribe, how much is Manhattan worth today and how much would that $24 be had it been invested in a solid compounding account and never touched to this day? According to Bloomberg, in 2018 Manhattan Island’s land value was a staggering $1.74 trillion. As staggering as that number is, here is the value of the $24.00 compounded daily at a rate of 8% for the 400 years or so it has been since the Dutch colonized what is now New York City: 1,888,477,782,469,425.50 (courtesy of moneychimp.com). This is a bit more than 1000 times the current land value of Manhattan. The value for the English crown as opposed to the Dutch Republic is even more starkly different. The value of New York to the British was drastically harmed because the English/British empire only had control of New York from 1664 to 1783, if we are assuming generously to the end of the American Revolution, a period of just more than a century. In contrast, Suriname served to benefit the Dutch, to the extent that imperial possessions are a benefit to those who hold them for an additional two centuries until it was granted independence in 1975. This additional time value of the colonial worth of Suriname as compared to New York City means that the English got a bad deal in gaining a colony of restive and independent-minded Yankees as opposed to a wealthy if obscure plantation colony that would have earned them prestige and trade income for far longer. Consider that.

Of course, part of the issue is that we do not know what the future will hold. If holding onto an investment at 8% compound for 400 years seems ridiculous, it is because we typically think of compound interest for ourselves only in terms of our lifetime. We do not know if we will have descendants 400 years in the future and do not consider how things may be made easier for them. It is impossible to think of what companies would still be around 400 years in the future to pay us the interest we are owed, especially as it balloons later on. Banks continually go out of business or are bought out, and who is to say that some new bank will honor the terms offered centuries ago, when the amounts grow larger and larger. And, it should be noted, any tapping of such a massive financial resource would drastically reduce the future value gained through the miracle of compounding interest. The moral of the story is clear, though, and that is provided that one’s horizon is long enough, the future value of even the smallest investment here and now is essentially infinite. If what we invest and do now has repercussions that will pay off hundreds or thousands of years of in the future, then the returns are essentially limitless even with modest rates of return. The opposite is also true, in that our debts, if the repercussions of our sins continue on for a long time, are also essentially infinite as well. This is also a matter that should draw our attention, as there are people nowadays who wish to be repaid for debts going back hundreds of years, and they are not inclined to be merciful.

About nathanalbright

I'm a person with diverse interests who loves to read. If you want to know something about me, just ask.
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