Tuesday, August 27, 2013

Whiteside's corollory of Einstein's supposed law of compound interest ...

As explained in the last point, Einstein is often credited, probably wrongly, with having made a statement on the long term impact of compound interest. along the lines of

"Compound interest is the most powerful force in the universe"

Whether or not he actually said this, is is certainly true that the cumulative effect of compound interest over a perid long enough to allow an investment to double repeatedly in real value - which requires a period of some decades and interest rates which are nearly always above inflation - can be dramatic.

Unfortunately the converse is also true and this gives rise to what I shall call "Whiteside's Corollory"

"Negative real interest rates, if sustained continuously for a decade or more, are one of the most destructive things which can happen to an economy."

Britain has already had rock bottom interest rates - well below the rate of inflation, and which therefore have the effect of destroying the purchasing power of savings - for longer than the present government has been in office.

This is only sustainable as a short term measure and only justifable in an economic emergency.

I happen to believe that the catastrophic economic legacy left behind by the last Labour government was such an emergency and accept that there are extremely good arguments for the Bank of England's declared policy of not increasing interest rates until unemployment drops below 7%.

Nevertheless a policy of negative real interest rates remains harmful to savers and extremely damaging in the long run.

Britain's long-term economic strategy needs to ensure that interest rates go back above inflation as soon after unemployment drops below 7% as can be achieved without the sort of sudden shock which might choke off the recovery. And thereafter they need to stay there.

There might be a temptation for someone reading this post to ask if I am criticising the government's economic policy.

Actually no, because the most important precondition for getting interest rates back into positive territory is to cut the deficit, which the coalition government is trying extremely hard to do.

But I am sounding a warning why cutting the deficit, and returning interest rates to positive real levels, must remain an economic imperative for this and any future government.

1 comment:

Jim said...

well, you are on the right track in your thinking. Interest rates must rise, though judging by your post you are using the hand cart found in old films and cartoons to head along the track. The answer lies in taking the Japanese bullet train.