I’m teaching exponential relationships to my class tomorrow morning and one of the applications of this understanding is obviously debt.
We just got finished discussing linear relationships last week, and it got me thinking: why is the accumulation of interest not linear? You’ve only borrowed the principal, so in my mind, if you’re going to have interest, it would be proportional to the amount of the principal you haven’t paid off yet.
Thinking like a lib (or maybe not since I can’t understand the way it actually works), the lender would be unable to access a certain amount of money that they previously did have access to, and thus would be privy to a proportion of that amount. As you pay on the principal, that amount should go down because they have more access to the money they previously had access to.
What purpose does your interest creating more interest serve other than simply to siphon money from the ones that need to borrow and those that have enough to lend?
Obviously that is the reason, but I’m just curious if there’s an actual reason they have, or if they really are just that blatant.
Personal failure
Simplicity of tracking the balance owed
Compound interest is more powerful than simple interest, so of course we use it for everything
I see the personal failure one used more often and in multiple forms. “Pay off your debt each month and your credit card won’t charge interest,” or “If you didn’t understand the terms of the loan, you shouldn’t have signed it/read the fine print.”
I don’t know why certain types of loans use simple interest instead of compound interest other than as an alluring alternative that is often offered after someone is already trapped in a cycle of credit card debt. Since there is a period before simple and compound interest meet, I assume they have calculated that profits will be higher for simple interest in that case, but it could just be marketing after someone was burned by compound interest.
An important point I noticed in the third paragraph of your question that you didn’t explicitly ask about is the difference between bank finances vs personal finances. Access to money for banks is far different than for individuals. This may be too much for your students, but you may find it interesting. I definitely will not be able to explain all of this sufficiently:
Banks do not need to keep enough money on-hand to pay off all of their debts at once. There is a set minimum they must keep. Everything else gets invested/leveraged elsewhere, including the debts that are owed to them. This is something individuals can also do to manipulate interest in their favor (to a lesser extent), but banks are also insured by the state and in some ways operate as issuers of the states money. This last part is explained within modern monetary theory and allows them to do fucky things with money.
When you have access to what are essentially unlimited streams of money, the rules for borrowing and lending don’t affect you the same as when your financial streams are limited.
This is fractional reserve banking / money multiplier, and turns out to be a myth: https://www.youtube.com/watch?v=cDNSNX48Kmo
I’ve never heard of private banks doing this; they certainly don’t in the US. That’s what central (i.e. state) banks or, in the case of the US, the Treasury do.
The most succinct MMT explainer I’ve found so far for is JT’s: Why The Government Has Infinite Money. The show notes on further resources are excellent.
I honestly don’t think that MMT holds up to scrutiny. It seems like a charming theory, but it only works when applied to the US dollar. If any other country decided to simply print money to fund their government budget, they’d quickly run into hyperinflation. The US gets away with it (for now) due to their extraordinary privilege of having the hegemonic global reserve currency.
As I have understood it, private banks are also involved in money creation, as the interest they charge on loans is considered “new money.” Then again, not even liberal academics can fully explain how money is created (within their ideological boundaries of course). They have some ideas, but nobody commits to defining it.
This is not true at all. Hyperinflation is very rare and only happens under specific, known conditions. It’s quite avoidable, except if you’re a small country that the US is trying to regime change (in which case all bets are off anyway).
PEGS Institute: What Caused Hyperinflation In Weimar, Zimbabwe And Venezuela?
It’s not like the US is unique in having fiat monetary sovereignty. AFAIK every country that has monetary sovereignty today is using a fiat money. Here’s a copypasta from a comment of mine on a post about China’s economy:
That doesn’t make any sense. The interest I owe on my loan is the opposite of money: it’s a hole I’m obligated to fill with money. It means I have to acquire money from somewhere, somehow to pay that interest or else default on my loan. In this sense, private banks are a drain on the economy. The neoliberal financialization of the US and other countries is creating debt deflation. Michael Hudson’s Killing the Host is about (PDF).
On fractional reserve banking, thank you, I wasn’t aware.
And on MMT, again, thank you for providing more sources. I didn’t want to type up a long post on this, so my comment was VERY generalized.
JT’s video was good, but there are plenty of more in-depth sources around. I believe it was either RevLeft or Guerilla History that had some of the academics who came up with this theory on their show sometime in the last year as well, which are a good listen.
I hadn’t even considered the difference between bank and personal finance. Thank you for you well thought out response, Comrade.