I love stories that illustrate the power of compound interest.
One of my favorite goes back to the days of the Roman Empire.
Brutus and Caesar
Caesar was a great politician but like all politicians he had his share of enemies. In order to insure that his children were taken care of if he met an early demise, he instructed he instructed his friend Brutus to set up a trust for his children with $1,000 Roman dollars.Of course, Brutus was not the most trustworthy guy. He skimmed off a penny and set up a trust for his own heirs invested in safe government bonds yielding 3%. Caesar's children got $999.99. Brutus left instructions that no one was to touch the money he put in trust for 2,021 years.
How would that work out? One cent compounded for 2,021 years at 3% would grow to this.
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| Source: https://www.omnicalculator.com/finance/cagr |
I believe a number with 21 zeros behind it is called a sextillion.
We are talking about one penny growing to $879 sextillion if compounded at 3% annually for 2,021 years.
That is $879, 085, 535 trillion.
The GDP of the United States in 2021 was $23 trillion.
The GDP of the entire world was $94 trillion.
The wealth of the total world is estimated to be $418 trillion.
In other words, one single penny compounded at 3% going back to the Roman Empire would be greater than all of wealth in the world today by a factor of over 2.1 million times.
If one penny could grow to that sum over the last 2,000 years why isn't there more wealth in the world today?
A big reason is that people rarely can keep their hands off the money. Compounding only works if interest compounds on interest. Most people can't do that. They spend the income as soon as they earn it.
The biggest reason is that the original investment capital is lost and the compounding stops with it. Brutus thought he was being smart by investing in the safest investment around-government bonds.
The biggest reason is that the original investment capital is lost and the compounding stops with it. Brutus thought he was being smart by investing in the safest investment around-government bonds.
Unfortunately, those bonds were Roman Empire bonds. The empire fell apart and the government bonds became worthless. Not only was the compound effect lost but so was the original penny.
The Brutus and Caesar story really drives home how powerful compound interest is. In fact, it is fair to say that compound interest over time is an impossibility based on the insidious way it works. It is simply so powerful that any borrower who is subject to its terms cannot keep up and will end up being buried beneath it. Anyone paying compound interest eventually cannot run fast enough, or make enough, to pay what is owed.
Those that are successful in fending off the forces of compound interest over the long-term usually do so only because they are able to issue new notes by enticing new lenders to loan them money. They pay off the old notes and interest with promises built on tomorrow and the faith of that lender that the money will be paid off. It often is not.
The end result of this process is default and bankruptcy. This is how the system equalizes. Over time, a lot of borrowed money simply does not get paid back. That is why one penny invested 2,000 years ago didn't change the world. The returns on the investment are gone along with the original investment. This is the harsh rule of investing in bonds, stocks or anything else. Money is made and money is lost. There are winners and losers over time.
The Brutus and Caesar story is well worth remembering as we see what is transpiring in the world's debt markets right now.
Global debt levels are higher than they have ever been.
There is somewhere over $250 trillion in debt in the world today and on its way to $300 trillion.
Those that are successful in fending off the forces of compound interest over the long-term usually do so only because they are able to issue new notes by enticing new lenders to loan them money. They pay off the old notes and interest with promises built on tomorrow and the faith of that lender that the money will be paid off. It often is not.
The end result of this process is default and bankruptcy. This is how the system equalizes. Over time, a lot of borrowed money simply does not get paid back. That is why one penny invested 2,000 years ago didn't change the world. The returns on the investment are gone along with the original investment. This is the harsh rule of investing in bonds, stocks or anything else. Money is made and money is lost. There are winners and losers over time.
The Brutus and Caesar story is well worth remembering as we see what is transpiring in the world's debt markets right now.
Global debt levels are higher than they have ever been.
There is somewhere over $250 trillion in debt in the world today and on its way to $300 trillion.
That is also undoubtedly the highest it has ever been.
The United States now has $30 trillion in federal debt.
Debt is up $10 trillion over the last 5 years.
Households in the U.S. have borrowed another $16 trillion ( $11 trillion in home mortgages, $1.6 trillion in student loans).
To put those numbers in context, Russia's entire GDP last year was $1.5 trillion.
The United States has various debt obligations totaling about $50 trillion just between governments and households. We are not even talking about corporate or business debt.
That debt requires interest payments.
The low-interest environment over the last decade has acted as an incentive for a lot of debt to be issued without a whole lot of costs to the borrower.
That may be about to change.
Interest rates are surging around the world.
One thing is sure.
The higher amount the debt load and the more leveraged the economic system is, the more pain that will be experienced as interest rates rise.
Look at the increase in yields on the 10-year government bonds since the beginning of the year.
The interest rate has gone from 1.52% to 2.35% since the end of the year.
The 10-year Treasury rate is an important benchmark as home mortgage rates are typically set off of that yield.
What has happened to home mortgage rates recently?
Last summer the 30-year rate was at 2.77%. It is now almost two percentage points higher at 4.67%.
The typical mortgage payment for a new homebuyer has gone up 24% in just the last month alone due to the interest rate increases. The average mortgage payment for a new homebuyer is over $500 per month higher than it was on January 1.
As interest rates increase more and more borrowers are going to feel the pain.
There is no greater point of potential pain than what higher interest rates will mean than to the federal budget.
$30 trillion of debt now needs to be serviced. It increases with each succeeding month with our deficit spending.
In fiscal 2021, that debt was able to be financed at an average interest borrowing cost of about 1.6%.
Interest expense on that cost was over $500 billion.
What happens to the federal budget if interest rates on federal debt increase?
The current CBO long-term budget forecast does not assume average interest rates on the federal debt will be higher than 1.6% until 2026.
The CBO still forecasts a 3% average interest rate in 2031.
This is an excerpt from the most recent CBO Long-Term Budget Forecast published in March, 2021.
However, as noted above, the 10-year rate is already at 2.35%.
With $30 trillion of federal debt consider what the additional costs to the federal budget are on each additional increase of 1% in the average interest rate.
+1% in average interest rate=$300 billion in additional interest expense on federal debt
+2% in average interest rate=$600 billion
+3% in average interest rate=$900 billion
An increase of 3% points still only gets us to an average interest rate on the debt of 4.6%.
That is still less than the average interest rate being paid on federal debt in early 2008.
In 2000 and 2001 the U.S. was paying an average interest rate of about 6.6% on its debt. That is 500 basis points (5% points) higher than we paid last year.
What would have to be done in the federal budget to pay for another $300, $600 or $900 billion in interest costs?
The entire Defense Department budget is around $700 billion.
Medicare is budgeted at $766 billion in 2022.
Social Security at $1.2 trillion.
All individual income taxes bring in $2 trillion.
Corporate tax revenues amount to $400 billion.
Simply stated, it would not take much for increased interest costs to wipe out the entire Defense Department budget.
Or all of Medicare.
Or require individual income taxes to be increased by 50%.
Or corporate taxes to be doubled
Are we seeing pain with inflation and increasing interest costs?
Yes.
However, the debt pain that might be just over the horizon could be like nothing we have ever seen.
The interest rate has gone from 1.52% to 2.35% since the end of the year.
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| Source: https://ycharts.com/indicators/10_year_treasury_rate |
What has happened to home mortgage rates recently?
Last summer the 30-year rate was at 2.77%. It is now almost two percentage points higher at 4.67%.
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| Credit: https://twitter.com/TaylorAMarr/status/1509563368838942727/photo/1 |
There is no greater point of potential pain than what higher interest rates will mean than to the federal budget.
$30 trillion of debt now needs to be serviced. It increases with each succeeding month with our deficit spending.
In fiscal 2021, that debt was able to be financed at an average interest borrowing cost of about 1.6%.
Interest expense on that cost was over $500 billion.
What happens to the federal budget if interest rates on federal debt increase?
The current CBO long-term budget forecast does not assume average interest rates on the federal debt will be higher than 1.6% until 2026.
The CBO still forecasts a 3% average interest rate in 2031.
This is an excerpt from the most recent CBO Long-Term Budget Forecast published in March, 2021.
CBO expects interest rates to rise as the economy recovers and then continues to expand, particularly in the latter half of the coming decade. The agency expects the interest rate on 10-year Treasury notes to average 1.6 percent over the 2021–2025 period and 3.0 percent over the 2026–2031 period. After 2031, the interest rate on 10-year Treasury notes is projected to rise steadily, reaching 4.9 percent by 2051. (Though higher than current rates, the projected interest rates are lower than they have been historically.)
With $30 trillion of federal debt consider what the additional costs to the federal budget are on each additional increase of 1% in the average interest rate.
+1% in average interest rate=$300 billion in additional interest expense on federal debt
+2% in average interest rate=$600 billion
+3% in average interest rate=$900 billion
An increase of 3% points still only gets us to an average interest rate on the debt of 4.6%.
That is still less than the average interest rate being paid on federal debt in early 2008.
In 2000 and 2001 the U.S. was paying an average interest rate of about 6.6% on its debt. That is 500 basis points (5% points) higher than we paid last year.
What would have to be done in the federal budget to pay for another $300, $600 or $900 billion in interest costs?
The entire Defense Department budget is around $700 billion.
Medicare is budgeted at $766 billion in 2022.
Social Security at $1.2 trillion.
All individual income taxes bring in $2 trillion.
Corporate tax revenues amount to $400 billion.
Simply stated, it would not take much for increased interest costs to wipe out the entire Defense Department budget.
Or all of Medicare.
Or require individual income taxes to be increased by 50%.
Or corporate taxes to be doubled
Are we seeing pain with inflation and increasing interest costs?
Yes.
However, the debt pain that might be just over the horizon could be like nothing we have ever seen.
When debt and the interest on it becomes too great there are only two ways out...it has to be inflated away or defaulted away.
Brutus would tell you it promises to be BRUTAL no matter how it plays out.
Compound interest guarantees it.
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