“The political fight in nearly every economy for thousands of years has been over whose interests must be sacrificed in the face of the incompatibility between financial and economic expansion paths. Something has to give, and until quite recently creditors have lost. This is the point that modern economists and futurists fail to appreciate. Financial claims run ahead of the economy’s ability to produce and pay. Expectations that interest payments can keep on mounting up are “fictitious,” as Marx and other 19th-century critics put it. When indebted economies and their governments cannot pay, bankers and investors call in their loans and foreclose.”

You may want to start with viewing the video at bottom, which explains one aspect of compound interest, i.e. exponential growth.

The following is an extensive citation from Michael Hudson, who in the full article, first explains the Oslo school of Reality Economics, the understanding and the role of compound interest in history since Babylonian times and its history to date, and finally, turns to the current crisis, and it is this part we are excerpting. We strongly recommend reading the whole article. We also add a very illuminating video interview on the history of taxation.

Michel Hudson:

“The political fight in nearly every economy for thousands of years has been over whose interests must be sacrificed in the face of the incompatibility between financial and economic expansion paths. Something has to give, and until quite recently creditors have lost. This is the point that modern economists and futurists fail to appreciate. Financial claims run ahead of the economy’s ability to produce and pay. Expectations that interest payments can keep on mounting up are “fictitious,” as Marx and other 19th-century critics put it. When indebted economies and their governments cannot pay, bankers and investors call in their loans and foreclose.

Why isn’t this the starting point of modern economics? As Herbert Stein famously quipped: “Things that can’t go on forever, don’t.” The accrual of savings (that is, debts) is constrained by the economy’s inability to carry these debts. Recognizing that no society’s productive powers could long support interest-bearing debt growing at compound rates, Marx poked fun at Richard Price’s calculations in his Grundrisse notebooks (1973:842f.) incorporated into Capital (III:xxiv). “The good Price was simply dazzled by the enormous quantities resulting from geometrical progression of numbers. … he regards capital as a self?acting thing, without any regard to the conditions of reproduction of labour, as a mere self?increasing number,” subject to the growth formula: Surplus = Capital (1 + interest rate)n

Individuals found it difficult to make use of the compound interest principle in practice. Peter Thelluson, a wealthy Swiss merchant and banker who settled in London around 1750, set up a trust fund that was to reinvest its income for a hundred years and then be divided among his descendants. His £600,000 estate was estimated to yield £4500 per year at 7½ percent interest, producing a final value of £19,000,000, more than thirty times the original bequest.

Thelluson’s will was contested in litigation that lasted 62 years, from his death in 1797 to 1859. Under William Pitt the government calculated that at compound interest even as low as 4 percent, the trust would grow so enormous as to own the entire public debt by the time a century had elapsed. This prompted legislation known as Thelluson’s Act to be passed in 1800, limiting such trusts to just twenty?one years’ duration. By the time all the lawyers were paid, “the property was found to be so much encroached on by legal expenses that the actual sum inherited was not much beyond the amount originally bequeathed by the testator.”[6]

But the savings of the living have continued to mount up. The banker Geoffrey Gardiner observes that in the late 1970s, “the burgeoning oil revenues of the producers were further gilded by the addition of high interest earnings. At their highest British interest rates had the effect of doubling the cash deposits of the oil-producers in only five years, or 16.3 times in twenty years! … The wisdom of an earlier age, which had led to the passing of ‘Thelluson’s Act’ to discourage the establishment of funds which compounded interest indefinitely, had been forgotten.”[7]

In his famous essay on usury, Francis Bacon observed: “Usury bringeth the treasure of a realm into few hands, for the usurer, being at certainties, and the other at uncertainties, in the end of the game most of the money will be in the box, and a State ever flourisheth where wealth is more equally spread.” The French socialist Proudhon echoed this basic principle in 1840, in his axiom that the financial “power of Accumulation is infinite, [yet] is exercised only over finite quantities.” “If men, living in equality, should grant to one of their number the exclusive right of property; and this sole proprietor should lend one hundred francs to the human race at compound interest, payable to his descendants twenty-four generations hence, – at the end of 600 years this sum of one hundred francs, at five per cent., would amount to 107,854,010,777,600 francs; two thousand six hundred and ninety-six times the capital of France (supposing her capital to be 40,000,000,000, or more than twenty times the value of the terrestrial globe!”[8] Hopes to increase human welfare through higher economic productivity would be stifled, Proudhon warned (in good St. Simonian fashion), if the self-expanding power of interest-bearing claims were not checked by policies to replace debt with equity investment.

The moral is that no matter how greatly technology might increase humanity’s productive powers, the revenue it produced would be absorbed and overtaken by the growth of debt multiplying at compound interest.

…

Every country has seen its ratio of debt to national income rise in recent years. Most bank credit – some 70 percent – is for real estate mortgages, reflecting the fact that real estate remains the economy’s largest asset even in today’s industrialized world. These loans increase the volume of debt attached to the economy’s property and income streams. Also rising are corporate debt/equity ratios. Bankers begin to extend credit against what they project that property prices will be worth in the future, given current rates of asset-price inflation. The dependence on credit increases the debt burden.

Minsky described this as the third and final “Ponzi” phase of the financial cycle. The term was coined to describe Carlo Ponzi’s practice in the 1920s of promising much higher returns to investors than they could earn elsewhere. He pretended to make arbitrage gains by buying international postage stamps and cashing them in for different currencies, profiting from shifts currency values that were not reflected in the International Postal Union’s price policies. In reality, he didn’t use the money for this purpose at all, but simply repaid early subscribers to his scheme out of money that new investors were putting in, believing that his high payouts to early investors reflected actual trading gains.

It seems ironic at first glance – but quite logical when one stops to think about it – that the largest and presumably most secure borrowers are the first that are able to enter into this “Ponzi” stage of being able to most easily add the interest onto their existing debt balance, year after year. The irony is that precisely by being so large and prestigious, the leading classes of borrowers tend to become insolvent faster than anyone else: the U.S. Government, foreign governments, real estate investors, and the biggest banks.

The world’s largest borrower is the U.S. Government. Its debt now amounts to some $— trillion. It has been built up by running budget deficits – at first for military spending, and since 1980 by slashing taxes on the higher wealth brackets, which have become the largest backers of political campaigns. One could say that instead of taxing the rich as formerly in accordance with the philosophy of progressive taxation, the government now borrows from them and pays them interest.

Most of the growth in America’s public debt since the nation went off gold in 1971 has not been financed by U.S. savers, but by foreign central banks, which find themselves flooded with dollars thrown off by America’s foreign military spending and widening trade deficit. The problem is that after central banks agreed in 1971 to stop settling balance-of-payments deficits in gold, the only alternative seemed to be to keep their central-bank reserves in the form of loans to the U.S. Government, recycling their balance-of-payments surpluses by buying U.S. Treasury bonds. America’s foreign debt has soared far beyond its ability to pay in any foreseeable future, even if its politicians were willing to do so (which they are not).

One result is that despite the fact that most Asian and European voters oppose the U.S. invasion of Iraq and related global military buildup, the international financial system has been set up in a way that obliges foreign governments to finance it. In fact, the United States is running up about $50 billion in interest charges each year to countries such as China – and simply adds this amount to the bill it owes.

This is how Brazil and other Latin American governments operated in the financial sphere before the Third World “debt bomb” exploded in 1982 when Mexico teetered on the brink of default. Each year they would ask the international bank consortium to lend enough more to cover the interest falling due – in effect, to add the interest onto the loan balance. Their debts grew at compound interest, doubling and redoubling exponentially every ten to twelve years at the then-normal annual interest rate of 6 to 7 percent. In effect, banks were paying interest to themselves, using Third World debtors as vehicles in what was becoming an increasingly fictitious global economy. It was fictitious because there was no way that the debts really could be paid. They had grown beyond the point where this was feasible economically, to say nothing of politically.

For governments less powerful than the United States, the price of getting the world’s commercial banks to keep rolling over their loans was to submit to strict political conditions laid down by U.S. diplomats. To qualify as a “good client,” third world debtors had to pursue deflationary monetary policies laid down by the International Monetary Fund and trade-dependency policies dictated by the World Bank. These programs made their trade balance worse and worse, thereby preventing them from working out their debts in practice. This made the global economy increasingly polarized and unstable.

Lending to these countries resumed after §990 to debtor governments that agreed to obey creditor demands that they pay their debts by selling off their public enterprises and national infrastructure. These sales led to much higher prices charged for basic services, impairing their competitiveness and hence making a future international debt crisis inevitable once again.

After governments, the leading borrowers are real estate investors. They have followed the same strategy as Third World governments, and bankers have been equally facilitating. Speculators keep ahead of the game as long as property prices increase at a higher rate than the rate of interest charged by the banker, so that they can sell their asset at a capital gain. The idea is to use “other peoples’ money” – or more accurately, bank credit – which is created electronically rather than representing savings that people have built up.

Bankers succumb to a bubble mentality, going so far as to make “negative mortgages” – debts that are not paid off at all, but keep adding the accrual of interest to the debt burden. Investors buy real estate and other assets by taking out loans so large that the revenue their collateral generates does not even suffice to carry the interest charges, not to mention paying down the principal. But real estate has become so important to their bankers that when their rental income fails to pay the interest charges falling due, most bankers are willing to be patient and simply let the debt service mount up. The interest that falls due is simply borrowed – in effect, added onto the debt in an exponentially rising curve.

The hope of lenders and borrowers alike is that the latter can sell their homes or office buildings at a high enough price to cover the mortgage charges and still keep a “capital gain” (mainly the land’s site value beneath these properties) for themselves. Well-meaning academics and journalists with the usual array of prestigious credentials are hired to explain that all this adds to “capital formation” and “wealth creation,” and hence should be taxed at only half the rate at which earned income – wages and profits – is taxed. This tax favoritism for debt-financed speculation shifts the fiscal burden onto labor and industry.

But real estate prices may plunge when the debt overhead grows too large, leaving property owners with negative equity. Many simply walk away from their property, leaving the banks holding the bag – a portfolio of bad debts. This may leave banks with negative equity if they owe more to their depositors and other creditors (other banks, the government’s central banks, holders of their own bonds and commercial paper) than their portfolio of loans is worth.

This was the point at which Citibank and Chase Manhattan were said to be in back in the credit crunch of 1980. They saved themselves by explaining to financial officials (mainly their own former managers) that their failure would cause such widespread dislocations that it would bring down the economy, if not the government currently in office. They were deemed “too big to fail,” and were allowed to rebuild their asset base and capital reserves by holding the interest rates that they charged for consumer loans high – around 20 percent – throughout the 1980s and into the 1990s, even as normal interest rates plunged to 5 percent.

For the economy at large – for businesses and individuals lacking the economic clout to keep the banks letting their interest arrears mount up – most borrowers are dependent on the banking system’s own expansionist ambitions. The result is a confluence of interest that makes the entire economy look like a Ponzi scheme. The largest banks for their part claim that they are “too big to fail,” much as the U.S. Government has told foreign central banks and other dollar holders. The greatest need for such operations is enough new members to put in enough new money to pay investors who want to “cash out” and realize the return that has been promised. In this case the bankers play the role of demanding money – by stopping the practice of lending borrowers the credit to pay their interest charges.

“Ponzi borrowers” need their assets to rise steadily in price so as to keep refinancing their debts at high enough levels to cover the interest that accumulates. This exponential growth becomes more and more difficult to achieve. Defaults occur if assets fail to appreciate or begin to lose value. This leaves investors in such schemes – and ultimately, banks themselves – holding the bag. That is what occurred in Japan after 1990, and in the United States in 2007. It is the third and final stage of credit flaming out. And as F. Scott Fitzgerald put it, flaming youth ends when there is no more money to burn.

The largest economic sector is real estate, and it remains the key to any economy’s long-term dynamics. The U.S. real estate bubble of the late 1990s and early 2000s illustrates a repertory of tactics employed by the central bank to inflate asset prices. Three tactics are classic: (1) lowering interest rates; (2) stretching out debt maturities; (3) reducing the amount of money (“equity”) that asset buyers must put down. As Alan Greenspan recommended, homeowners borrowed against the rising market price of their real estate to maintain consumption levels that their earnings no longer were sustaining. [CHARTS]

As the financial sector becomes richer, it translates its economic power into political power, backing lawmakers who shift taxes off property and finance onto labor and industry, depressing the domestic market. Indeed, financialization requires the economic process to be increasingly politicized in order to keep evolving. Recognizing that the growth of debt entails tightening bankruptcy laws independent from democratic oversight and control, and indeed actively militates against it, the financial sector’s political lobbies and their academic cheerleaders demand that central banks be made independent from democratic political overrides.

I almost hesitate to use the term “parasitized” in an academic analysis, but biology provides a repertory of how the financial sector works to take over the economy’s policy-making. I use the term “parasitic finance” to explain how the financialization process intellectualizes itself. The strategy of parasites in nature is not simply to drain their host’s nourishment for themselves, but to take over its brain – its “planning function,” so to speak – so that the host imagines that it is feeding itself while actually it is nourishing and protecting its free rider.

Financialization transforms economic thought itself, including the economy’s statistical self-portrait. The classical 19th-century economists would have viewed it as an unproductive distortion of the “real” economy of industry, agriculture and commerce. Such a value judgment needs to be changed (“modernized”) in order for financialization to promote the idea of asset-price inflation as “wealth creation” for the population at large to make them willing and even eager to go deeper into debt in the belief that this is the easiest path to wealth, conceived as a positive net worth of inflated asset valuations relative to debt. But the financial sector’s rake-off is described as “providing a service,” not as a zero-sum transfer payment.

The bursting of America’s financial bubble not only wiped out much financial capital and savings, it also extinguished much of the pseudo-academic Junk Economics that rationalized the bubble economy’s asset-price inflation as “wealth creation.” Behind the overvaluation of property lay a belief that inflating prices for real estate and corporate stocks added as much to the wealth of nations as creating new fixed capital. What had been welcomed as a postindustrial economy turned out to be the kind of rentier economy that classical economists and Progressive Era reformers had tried to replace with a market free of the kind of “wealth formation” that the Federal Reserve sponsored for more than two decades. After Mr. Greenspan he left the Federal Reserve Board in 2006, his two-term tenure as cheerleader for encouraging irrational exuberance in the real estate market was seen to have built up fictitious wealth – paper valuations which collapse after 2006, leaving intact the debts that had been run up. His reputation as “maestro” turned to that of Bubblemeister.

How could economists and government officials ever have believed that the exponential growth of debt and asset prices could go on without constraint? If it is true that “a trend that can’t go on forever, won’t,” then what were the factors that bring such trends to an end?

For one thing, a rising debt means more income devoted to interest, amortization and other financial charges, not a demand for goods and services. And the higher property prices and stock prices were inflated, the more debt homeowners and corporate raiders had to take on to acquire these assets. One of the problems suffered by Ponzi debtors is that they no longer can afford to keep up their living standards. Market demand shrinks, constraining corporate profits. Price/earnings ratios rise even further, lowering the yield of dividends accordingly. This means that it costs more and more to purchase a retirement income – and part of the Greenspan financialization process was to pay Social Security (and health insurance) out of the income stream projected for prior savings. Higher capital gains meant lower yields of interest and dividends. The bubble economy thus had internal contradictions over and above the behavioral tendency for stability and good times to breed an overly optimistic financial instability.

One form of tortured logic was the idea of reversing the early Internal Revenue Service practice of taxing capital gains as normal income, on the ground that it increases the recipient’s balance sheet in the same way as earning income and saving it. John Stuart Mill expressed the classical idea of taxing the rise in land prices on the ground that it was an “unearned increment.” Post-classical thought tried to construe these gains as being earned – e.g., by “waiting” – yet simultaneously argued that they were really income at all and hence should not be taxed. Failure to tax such asset-price gains leads investors to speculate rather than to invest productively.

Another victim was the misnamed neoclassical school of thought – misnamed because it actually set out to replace classical political economy’s definition of cost-value in terms of the technologically necessary costs of production. Post-classical price theory adopted a pragmatic accountants’-eye view that focused on whatever out-of-pocket expenses were incurred by current buyers and operators of enterprises, even when these were loaded down with debts, exorbitant executive salaries and stock options, high rates of dividend payouts at the hands of “shareholder activists” (the new euphemism for corporate raiders), inflated property prices and patent fees – the institutional property and financial overhead that classical economists had termed economic rent. The distinction between cost-value and market price that formed the core of classical economics was lost.

The most blatant misnomer was “neoliberalism.” Classical liberalism sought to free markets from rentier claims for unearned income – landrent, monopoly rent and financial overhead. To neoliberals, a free market was one “free” of government regulation – a market where predatory finance and extortionate monopoly pricing had a free hand to engage in zero-sum exploitation of the economy at large. For pension and Social Security funding, new taxes and other rules are needed to force “savers” to contribute, however unwillingly. This was the kind of forced saving that the democracies of the 1930s had criticized when it was practiced only by Nazi Germany and Stalinist Russia.

The public domain and its natural monopolies were being privatized on credit. This raised the price of basic infrastructure services, without necessarily increasing their quality or supply – and often doing just the opposite. So the philosophy of privatization – and the ideology that economies did not need government – became another victim of the bubble economy. The concept of a mixed economy with mutual checks and balances, with the government providing basic infrastructure at cost to minimize the economy’s price structure while taxing away economic rent and the “free lunch” was lost. Neoclassical and neoliberal economics denied that there was any such thing as a free lunch – although that was what the post-industrial economy’s wealth-seeking was all about.

Instead of the industrial economy that economic futurists around the turn of the 20th century had anticipated, a neo-rentier economy emerged. It was driven not by what the classical economists called productive loans – those that provided borrowers with the means to earn the revenue to pay off the loan with its interest charges, and still keep normal profit for themselves by creating new means of production – but increasingly by predatory credit, above all by loans extended simply to enable buyers to bid up prices for assets already in place.

A rising proportion of debts cannot be paid, including government debt (especially foreign debt), real estate speculation, corporate takeover debts and many personal debts. The economy’s shape changes as debtors default, creditors foreclose and governments are forced to privatize the public domain as an alternative to defaulting or repudiating their debts outright. All this is called a “free market,” as if the only form of economic freedom is from government.

It would better be viewed as a free lunch for the financial and property sector. It is a travesty of the historical idea of liberty from the third millennium BC through classical antiquity, when the meaning of liberty connoted primarily freedom from debt bondage. This is the liberty to which early Judaism and Christianity referred. It survives in the inscription on America’s Liberty Bell in Philadelphia from Leviticus 25: “Proclaim liberty throughout the land, and to all the inhabitants thereof.” The Hebrew word corresponding to “liberty” in this inscription was d’r’r (deror), cognate to Babylonian andurarum, the word rulers used for Clean Slates. These royal proclamations comprised three interrelated policies: cancellation of personal debts, freedom for bondservants who were pledged to creditors as collateral to return home to their families of origin, and return to their customary holders of land and crop rights that had been pledged to creditors as collateral. Viewed in this long-term perspective, financial freedom for government means the right to infringe on the liberty of debtors and indeed, entire debtor economies.

The U.S. economy’s fate threatens to go far beyond a “Minsky moment” in which markets crash to wipe out the overhang of speculative debt. Creditor interests have turned their economic power into political power and shift taxes onto labor and industry, off the financial sector and its major customers (real estate and monopolies), even as the economy leaves the stage of asset-price inflation and enters the negative-equity stage in which the debts attached to much property, many companies, financial intermediaries and money management firms exceed the post-inflationary market price of the assets collateralized (“financialized”) by this debt.

The reverberations of financialization radiate outward from the U.S. financial sector to the fiscal system (the Treasury’s tax policy, cutting taxes on finance and on property income pledged to pay interest overhead), global diplomacy (suspension of the balance-of-payments constraint on the central bank’s ability to cut interest rates), economic theory, and the statistics which reflect the categories of economic theory.”

2. Watch this video on exponential growth:

From Chris Martenson’s Crash Course in Economics, strongly recommended by Thomas Greco:

3. Michael Hudson on taxing unearned income