The Myth OfCompound InterestorA Basic Lesson In Financial Repression

Dateline: 14 December 2014

You’ve probably heard of the miracle of compound interest. It has gotten a lot of attention over the generations. I myself have pondered and marveled at how consistently saving a little, on a regular basis, over a long period of time, coupled with compounded interest, can make a person rich in later years. I’ve even expounded about this fundamental investment advice to my children, hoping they would grasp the wisdom of delayed gratification and disciplined saving.

But I must admit that I’ve always had a niggling feeling about the miracle of compound interest.  Is it truly a valid (or even desirable) approach to attaining wealth? 

Maybe some day I will discuss the desirability (or ethics) of seeking to pursue wealth by usury, but not today. In this little  blog post I’d like to address the validity of the miracle of compound interest. That is to say, does this so-called miracle really have a sound basis in fact? After giving this subject some serious thought,  I submit to you that it does not.

Theoretically speaking, it’s entirely possible to make a lot of money with compound interest. And it may be that there have been periods of time throughout history when the miracle of compound interest actually worked as the experts say it will. But I can assure you it has not been a logical or wise investment strategy for a very long time in this country. 

Furthermore, within the emerging new economic realities that we are all facing, the miracle of compound interest is a complete and total myth. As such, it is one of the worst bits of investment advice that you can follow.

Compound interest can not make anyone wealthy these days, and it has not made anyone rich in the last hundred years or so. This is the case because for the last hundred years we have experienced continual inflation, and inflation destroys the miracle of compound interest. Worse than that, inflation typically results in a negative real interest rate, which amounts to a compounded financial loss. This is known as financial repression.

For example, according to This US Inflation Calculator (as seen in the screen shot below), $20 in 1914 had the equivalent buying power of $474.87 dollars today. And the inflation calculator tells us that is a 2,274.3% rate of inflation.

In order for the miracle of compound interest to bear fruit in that hundred years, the interest earned on saved money would have to be more than the rate of inflation. There may have been periods of time when that was the case, but I don’t think it was the case very often or for very long.

The reality of compounded financial loss can be illustrated very easily by looking at today’s interest and inflation numbers. Let’s say you have $10,000 dollars in your savings account. It is probably earning less than 1% interest. To make this example easy, we’ll be generous and say you’re earning a full 1% on your money.

Now we’ll figure in the current inflation rate. These days our government tells us that the inflation rate is around 2% and that it has been around 2% for several years. But the government lies. As I’m sure you know, our government can’t be trusted to provide us with true financial numbers. By lying and deceiving us about these things, our government cheats and steals and mismanages even more of our money.

In a recent interview, John Williams of ShadowStats, says that the true inflation rate is between 5% and 9%. I heard another independent financial analyst say that he thought the inflation rate was around 6%. Suffice it to say that inflation has has been much more than 2% for many years. Let’s go ahead and assume that 6% is the number....

If the inflation rate is 6% and you are earning 1% on your savings, then you are losing 5% a year. Very few people see or fully understand that they are losing money because their bank account doesn’t show a loss. Here’s what I mean...

If you earn 1% simple interest, compounded annually, on your $10,000 savings, you savings account would show the following gains...

Year 1:  $10,000.00 x 1% interest = $100.00      
Total savings = $10,100.00

Year 2:   $10,100.00 x 1% interest = $101.00      
Total savings = $10,201.00

Year 3:   $10,201.00 x 1% interest = $102.01     
Total savings = $10,303.01

Year 4:   $10,303.01 x 1% interest = $103.03      
Total savings = $10,406.04

Year 5:   $10,406.04 x 1% interest = $104.06    
Total savings = $10,510.10

Year 6:   $10,510.10 x 1% interest = $105.10      
Total savings = $10,615.20

Year 7:   $10,615.20 x 1% interest = $106.15     
Total savings = $10,721.35

Year 8:   $10,721.35 x 1% interest = $107.21    
Total savings = $10,828.56

Year 9:   $10,828.56 x 1% interest = $108.29    
Total savings = $10,936.85

Year 10:  $10,936.85 x 1% interest = $109.37     
Total savings = $11,046.22

Thus we see that after ten years of 1% interest, an investment of $10,000 will earn $1,046.22 in interest. HOWEVER, the reality of the situation is that, even though the $10,000 has grown by 1% a year, and it shows an increase in money in the account, the purchasing power (the true value) of the $10,000 has actually DECLINED by 5% a year (as I explained above). So let’s look at the same account, showing the true, compounded loss of 5% a year.

Year 1:   $10,000.00 x 5% inflation loss = $500.00
Total purchasing value = $9,500.00

Year 2:    $ 9,500.00 x 5% inflation loss =  $475.00
Total purchasing value = $9,025.00

Year 3:    $ 9,025.00 x 5% inflation loss =  $451.25
Total purchasing value = $8,573.75

Year 4:    $ 8,573.75 x 5% inflation loss =  $428.69
Total purchasing value = $8,145.06

Year 5:    $ 8,145.06 x 5% inflation loss = $407.25
Total purchasing value = $7,737.81

Year 6:    $ 7,737.81 x 5% inflation loss = $386.89
Total purchasing value = $7,350.92

Year 7:    $ 7,350.92 x 5% inflation loss = $367.55
Total purchasing value = $6,983.37

Year 8:    $6,983.37 x 5% inflation loss = $349.17
Total purchasing value = $6,634.20

Year 9:    $ 6,634.20 x 5% inflation loss = $331.71
Total purchasing value = $6,302.49

Year 10:  $ 6,302.49 x 5% inflation loss = $315.12
Total purchasing value = $5,987.37

As you can clearly see, when we look at what is actually happening to the value of the $10,000 savings account over ten years, with a 1% interest rate, and a 6% inflation rate, there is no net gain in value at all.

The owner of the savings account may look at the total of his account and think the value of his $10,000 increased by $1,046.22, but it actually declined in value by $4,012.63.

That is a significant loss. Almost half of the investment has been lost. If that person worked, scrimped, sacrificed and saved $100,000 (instead of the $10,000 example) for their retirement years, their money would have lost $40,126.30 in purchasing power.

This little mathematical exercise reveals the wickedness of inflation. Some people refer to inflation as a ‘hidden tax,” but it is not a tax. It is government sanctioned, premeditated theft. 

Knowing this, the question arises…. What can a person do to preserve the value of his hard-earned savings? That is a difficult question that I think about quite a bit. There are no easy answers that I know of. But I may try to offer some suggestions in the future. If you have any solutions, feel free to share them in the comments below.