At Finweek and ValuationUp.com were big fans of compound interest. It’s quite simply the most powerful concept to understand in finance and underpins everything from the interest on debt to valuation. So it’s interesting to see just how old and universal this concept is: it turns out that the idea that loans can be made, and periodic interest payments can be accrue on those loans has been with us since we took the first steps to becoming agricultural.
A move to an agricultural society implies property rights: if you are to invest in preparing soil by clearing forests, removing rocks, digging up the earth, planting seeds and then caring for your crop you need to know that it will be yours to reap when its ready. Agriculture has always required large capital investment, but the returns can literally accrue for several generations, if not centuries. What’s interesting is that seed is a form of currency. Say you take 100 seeds, plant and care for them. If all goes well you should have 100 plants that each produce 100 of their own seed. So within a season you could take 100 seeds and make that 10,000. Now if you’re a farmer starting out you need seed. So very early on, there’s proof that people were buying seed and paying back out of future ‘capital’ growth. Animals were also loaned in a similar way – with payback in terms of a share of progeny. Investing seed or animal capital to share in the growth of the pool (the gene pool, if you think about it), is what we do today, just money was invented in-between. The invention of money meant that you could lend someone seed and be paid back in Silver, which could then be exchanged for something else. There is evidence that around 3000BC Interest rates in Sumeria were about 20% on these deals.
Compound interest was viewed as being morally suspect for a long time, and was derided as usury. This in part driven by a speculative credit boom that coincided with Silver mines in German and the Christian invasion of Islamic Spain. The ‘shaming’ of compound interest forced capital providers to invest in such a way that they could make a collective profit from what people did with their money…and so the venture capital business was born. It as no longer a sin to profit from the money one lent to an agent. However people who made a lot of money this way still felt guilty – its been suggested that wealth which 14th century banks accumulated in Italy lead so the banks owners investing in philanthropy as a way to ‘give back’. This investment allowed the Italian renaissance and pulled Europe out of the dark ages.
Religion has never been far from money and although ‘taking from the poor’ via interest wasn’t initially popular, the rise of Protestantism and its associated work ethic lead to increased tolerances from religious leaders that in turn allowed the middle class to accumulate capital. The Calvinists saw business as something you could pursue while caring for morals at the same time. Thus it was in the 16th century that compound interest became mainstream and acceptable again. In 1545 England passed laws allowing annual interest rates of up to 10%. Rather like taxing prostitution or drug trades this legitimised and regulated the trade that until then had been the domain of loan sharks (the micro-lenders of their time). Bear in mind though, that at this time if you wanted the farm land someone else had invested their life into getting ready, it was quite possible that you’d just fight them for it, so capital was still at risk.
In 1613 Richard Witt published ‘Arithmetical Questions’ – a landmark book that included tables of compound interest and formula for their practical application in merchants and traders. The book laid the framework for the English banking system, which remains fairly central to global financial trade.
The other side of the coin is that Karl Marx viewed compound interest as an evil force that allowed capitalists to have far more control than their proportional share of the assets they actually owned. It would be hard to argue against this today, even though communism clearly hasn’t been the answer to the problem.
Compound interest remains at the heart of the financial system. If you eat food its production has been financed by compound interest. It’s the same with your house, car, education and most likely the business where you earn your living. Interest rates vary widely – our systems are far more complex now and we also have a far more granular understanding of risk. Capitalism remains the dominant economic model and that is entirely due to compound interest. My guess is things will stay in the 10%-20% for a long time to come…