In­ter­est rates

Finweek English Edition - - BUSINESS -

At Fin­week and Val­u­a­tionUp.com we’re 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 hu­mankind first started farm­ing.

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 it’s 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 seeds of their own. So within a sea­son you could take 100 seeds and turn that into 10 000. Now if you’re a farmer start­ing out you need seed. There’s proof that very early on 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, it’s just that 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 the min­ing of sil­ver in Ger­many 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 is 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 – it’s been sug­gested that wealth that 14th-cen­tury banks ac­cu­mu­lated in Italy lead to the bank own­ers in­vest­ing in phi­lan­thropy as a way to ‘give back’. This in­vest­ment al­lowed the Ital­ian Re­nais­sance to take place 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 tol­er­ance from re­li­gious lead­ers that in turn al­lowed the mid­dle class to ac­cu­mu­late cap­i­tal.

The Calvin­ists saw busi­ness as some­thing you could pur­sue while si­mul­ta­ne­ously up­hold­ing morals. 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 the drug trade, this le­git­imised and reg­u­lated a trade that un­til then had been the do­main of loan sharks (the mi­crolen­ders of their time). Bear in mind though, that at this time if you wanted the farm­land some­one else had in­vested their life into get­ting ready, it was quite pos­si­ble that you’d sim­ply 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 for­mu­lae for prac­ti­cal ap­pli­ca­tion by mer­chants and traders. The book laid the frame­work for the English bank­ing sys­tem, which re­mains fairly cen­tral to global fi­nan­cial trade to­day.

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 this prob­lem.

Com­pound in­ter­est re­mains at the heart of the fi­nan­cial sys­tem. If you eat food its pro­duc­tion has been f inanced 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 bet­ter un­der­stand­ing of the gran­u­lar na­ture 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% range for a long time to come…

If you have a ques­tion/is­sue you’ d like to dis­cuss with us, then send an email to fin­week@val­u­a­tionup.com.

Newspapers in English

Newspapers from South Africa

© PressReader. All rights reserved.