Compounding the Problem

The payday lender Wonga has been in the news again for its appalling conduct towards the impoverished borrowers for whom it ruins lives and from whom it extracts, by one means or another, colossal amounts in interest payments. To be precise a rate of 5,853% compound on an annual basis. Except, of course, when it is charging itself for the overdue compensation it is required to pay to borrowers it had threatened with phoney legal firms. In this clearly deserving case it applied a much more civilised 8%.

We also hear a good deal about the role of interest rates in national economic policy and the mixed messages recently from the Bank of England about raising official interest rates from the long-standing historic low of 0.5%. Mind you, I doubt if the likes of Wonga take these into account when setting the malignant rates they charge to their unfortunate users.

The question of interest, the price charged for the use of money over time, has always been contentious. Over 800 years ago, Maimonides was the first to suggest a connection between interest bearing loans and economic growth. In the Industrial Revolution, interest was seen just as one of many prices – as was the view in Roman times (though Roman law held that debt was personal and didn't allow it to be transferred). In the USA some states have legal provisions against charges for the use of money that are deemed excessive (usury) – would that we had them in this country. I wonder why we don't?

The Medieval Christian Church saw banking as usurious regardless of the rate of interest. In fact the Old Testament (Deuteronomy, 23: 19 & 20) allowed interest to be charged only to foreigners! Islamic opinion of course includes the view that overt charges for the use of money can be sinful – along with excessive risk taking. No wonder Islamic banking is on the rise here as elsewhere, and a good thing too with these desirable principles.

In Victorian times thrift, saving and so the receiving of interest were hailed as virtues. This view carried on well into the 20th century as the noble inscriptions inside the late lamented Birmingham Municipal Bank in Broad Street reveal – 'Thrift radiates happiness' being one of them.

Of course, even if you are thrifty you need enough to live on in the first place, and there's no guarantee of that in this economy. These days, consumers are pressed to borrow even when they don't need to and those who have saved first and want to pay cash may well end up paying hidden subsidies to those people made impatient and prevailed upon to buy on credit.

I cannot assert strongly enough that unless good values are embedded in the individuals who operate an organisation, that organisation will, sooner or later, again begin to take advantage of vulnerable people.

At the national level, behind the view that interest rate cuts will stimulate demand are the presumptions that these favourable changes will be reflected in loans to business and that most consumers are borrowers. This only works if more people are borrowers than savers and it may not work at all if there's not a 'credit culture' – as in Japan some years ago when consumers reacted to lowered interest rates by saving harder.

Successive governments have attached great weight to official interest rates as an economic regulator. But interest is just one factor among many for economies, companies and individuals. Apart from the hapless people trapped in mounting payday debt, in these exploitative and unprincipled times interest has some importance but not as much as it once did when the Bank of England's lead was automatically followed.

But it's not just the rate of interest that's important in assessing consequences. It's the compounding of interest that can add remorselessly to national, corporate or personal debt with unethical lenders and borrowers eking a living on slashed benefits, zero hours contracts or minimum wages.

In his intriguing tale 'The Sleeper Awakes', HG Wells showed the dramatic effect of compound interest over very long periods. In the story, an investor wakes from a sleep of two centuries to find that the accumulated value of his investments had made him the owner of the world! And Einstein reportedly said that compound interest was the strongest force in the Universe!

The key point is that in compounding, interest attracts interest. If you deposit £100 in an account paying 10% compounded annually, with no withdrawals after one year you'll have £110 in the account, all of which earns interest in year two (since you and a new depositor with £110 should be treated equally). The total at two years is £121, and after three years you'll have £133.10. These multiples of your original sum; 1.1, 1.21 and 1.331 are called 'future value factors' which show how debts build up if repayments are missed. The impact is much worse at higher rates. For example, at a compound rate of 15% debt doubles over 5 years, quadruples over 10 and increases sixteenfold over 20.

The effects of interest rate changes over long periods can be enormous. Over a twenty-year period, doubling the interest rate from 15% to 30% increases liability nearly twelve fold. And putting off the evil day can cause enormous increases in the sum due. At 30% per annum £100 becomes £19,005 after 20 years but a staggering £261,999.60 after 30 years.

Thus can compound interest turn a modest sum into a king’s ransom. So debt rescheduling – either for individuals or indebted nations – must be carefully constructed if it is not to store up even more unmanageable problems for future generations.

The positive side of all this shows the value of early contributions to pension funds and reducing interest charges for struggling firms. Returns of over 50% are sometimes sought by venture capital firms (who, despite the enterprising name are scarcely adventure capitalists – preferring safe investments in the South East) and this sort of rate was charged on some bank credit cards before the financial crisis. (Incidentally, the annual equivalent rate of 2% per month compound is 26.8% not 24% - thus are bloated profits made). All these rates are trivial of course when compared to the grotesque usury of payday lending.

Investment means outlay before income. Adding together costs and returns separated in time and regardless of interest isn't comparing like with like. For each cost or return its equivalent value at the present is found by dividing by its future value factor. This process is called discounting. Then these present values are added up to give the net present value of the investment. Nothing ultra modern here – the rule was first recorded in 1582. But long before that, there were manuscript compound interest tables in the fourteenth century, and an understanding of compounding can be inferred from Babylonian tablets!

But in adopting this approach it is vital not to use too high a rate for discounting. The higher the rate, or the further into the future the cost or return is located, the less weight it is given. This can be very important. Discounting at a rate of 30% gives only one eighth the weight to tenth year returns compared to that from discounting at 5%, so discounting at high rates biases against projects where the higher returns come later on.

In contrast, 'patient money' reaps long term rewards – both strategic and political. And in terms of costs there can be crucial implications for future generations – as for example in the decommissioning costs of nuclear power stations. At a 15% rate a cost thirty years ahead is given only a quarter the weight of the same cost at 10% discounting. And at 30%, the weight of a thirty year cost is zero to three decimal places! So excessive discount rates are a potent force both for short-termism and leaving a legacy of dire environmental consequences.

In the field of personal finance, Governments have refused to set effective legal limits to rates. This has allowed vulnerable people to become victims of usury, trapped in perpetual debt to profit making companies. We know about Wonga and its like, but these despicable practices are nothing new.

A survey carried out in Birmingham a quarter of a century ago showed equivalent annual rates of over 100% for money lending to be common. At 100% debt doubles every year. This little publicised survey which should have prompted much needed reform found loans with annual rates of over 1000% - at which rate debt increases tenfold in a year. All this points up the importance to small borrowers of joining a Credit Union and avoiding this appalling usury.

Even at that time there was a case of loans charged at an equivalent annual rate of 4,822%! Quite competitive in comparison to Wonga. To illustrate the financial enslavement resulting from this dreadful usury, at this astronomical rate the liability from borrowing £1 would, in the absence of capital repayment, in eight years exceed the entire UK GDP!

Why does one government after another let these companies get away with this immoral conduct? I certainly hope that the Archbishop of Canterbury's initiative succeeds and Wonga and its like are driven out of business. It can't happen soon enough.