I’ve been following Tyler Cowen for years. Marginal Revolution, the blog he runs with Alex Tabarrok, is on my daily rounds of the web. One of Cowen’s themes is bigness: Bigness is good, or at any rate, the right kind of bigness is good. The way to freedom and prosperity for all is to grow the economy. Growth begets growth.
If you read enough by Cowen it becomes clear that the phenomenon of compound interest is at the imaginative center of his belief in bigness. What’s the route to prosperity, to bigness? Compound interest – and I believe Cowen holds that innovation is the way to compound that interest, though that’s a different discussion for a different day.
Compound interest is what happens when you put your money into a savings account and leave it there, year after year. It just grows and grows. How does that work?
You put some amount of money in a savings account. That’s called the principal. After an interval specified in the contract governing that account, the bank adds a bit of money to your principal. That is the money your principal has earned from the bank. We call that interest. If, as you are supposed to do, you refrain from withdrawing from your account, that interest will be compounded. For, when the bank pays interest at the next specified internal, it pays interest on the original principal plus the interest it had added to your account at the previous interval. And it keeps on doing this forever and forever. So, without you having to do anything, your money just grows and grows. And if you make continued contributions of your own to the account, as you are supposed to do, why so much the merrier.
Now, it is up to the bank to decide the rate and interval at which it pays interest on a savings account. That is within the bank’s control. As long as the bank is solvent it can continue to do this. The bank’s solvency depends on its ability to negotiate the current business environment.
The bank is able to pay you interest because it takes your money and loans it to others (or otherwise invests it) at a rate that is higher than what it is paying to you. As long as the bank’s money-making activities are successful, everyone is happy. But what happens if the bank is unable to meet its obligations?
Whoops!
It happens, of course it happens. Setting dishonesty and ordinary incompetence aside, bankers don’t control the world. So it might happen that, through no fault of its own, a bank’s management fails to generate enough income to cover its obligations. That’s troublesome. Add incompetence and dishonesty back into the mix and things just get worse.
Now, how do you generalize that relatively self-contained story to society as a whole, because that’s what you need to do if you are going to use the phenomenon of compound interest to animate and illuminate your worldview? Well, wouldn’t you know it, economists have developed models of economic growth – Robert Solow won the 1987 Nobel Prize in Economics for one such model. Of course a model is only a model, its not the whole world. Economists know that, we all know that.
But if the model is sufficiently rich, why it is easy to get lost in it, tinkering around, fitting and refitting, revising, even challenging and opposing. One can get lost in there. What then?
What then?
Bankers can pay compound interest as long as they can control their operating environment. But really, can bankers always and ever control their operating environment? No. The most skillful surfer in the world cannot control the wave, ever. S/he can only ride it, and ride it well.
At what point does the mystique of compound interest turn into a myth of total control?
* * * * *
On a different note, Cowen likes to travel, he likes food, and he likes to have conversations with interesting people. What kind of conversation would he have had with Anthony Bourdain?
No comments:
Post a Comment