According to a recent article in Fortune magazine, “Boomers” are being forced to “unretire” due to inadequate savings. That’s bad, of course, but the real point of the article is a wonderful (wunderbar?) new proposal in Germany. The idea is for the government to fund retirement accounts for children between age six and eighteen. Cash would be deposited, and the interest would compound. As described by Fortune,
[T]he country’s government would pay out 10 euros ($11) a month to children in education under this new plan. Over 12 years of eligibility, this could accumulate to more than 1,440 euros per child, not counting the potential investment gains from compounding interest over the decade. Then, from the age of 18 onward, they can add personal funds to the accounts and enjoy tax-free profits. However, that cash will become accessible to account holders only when they reach retirement age — which is currently set at 67 in Germany.
This sounds good, but there is a significant problem the article does not address — and that is not the magic of compound interest, but the danger of it.
 |
| Aristotle |
Danger? Yes. You see, compound interest is not merely interest on interest, traditionally considered usury, “usury” being taking a profit where no profit is due. That may be the case in some instances, but what we’re looking at is when compound interest is legitimate, at least in moral philosophy. That is, instead of distributing the earnings of capital for use as consumption income, the earnings are retained and used to finance more production.
In moral philosophy, it is perfectly legitimate to reinvest profits and “compound the interest.” In finance, however, it is quite a different matter. This is because true investment (as opposed to speculation) means putting money into something that generates a profit. The profit — interest — can then be spent on consumption . . . which was the whole reason to produce something in the first place.
 |
| Adam Smith |
This is consistent with Adam Smith’s first principle of economics as stated in The Wealth of Nations. As Smith put it, “Consumption is the sole end and purpose of all production.” This is also the heart of Say’s Law of Markets, derived from Smith’s first principle. Interestingly, Smith did not invent his own first principle of economics (it can be traced to Aristotle, if not earlier), nor did Jean-Baptiste Say invent the Law of Markets named for him. Say just expressed it better than previous economists.
As Smith maintained, the purpose of production is consumption. Production obviously must precede consumption because you must have something to consume before you can consume it. Absent theft or charity (the former unacceptable, the latter unrealistic as the basis of an economic system . . . especially when what is given to one as charity is stolen from another), there are only two ways to obtain something to consume.
One, you produce a good or service for your own use, or two, you produce something to trade to another for what the other produced. That, in a nutshell, is the basis of any rational economic system. The purpose of production is consumption, and production must precede consumption; if you don’t produce, you can’t consume.
 |
| Jean-Baptiste Say |
Thus, as Say’s Law of Markets is usually oversimplified, production equals consumption, therefore supply generates its own demand, and demand, its own supply.
What happens, however, when someone uses what is produced to produce more goods and services instead of consuming what has been produced? That is, when someone reinvests profits instead of spending them on consumption? That is essentially what compound interest does.
Obviously, if someone produces more than he or she consumes (directly or indirectly), Say’s Law is thrown out of balance. Goods are produced which are not consumed because others (as Say pointed out) are not producing enough to exchange for what one has produced. The economy is thrown out of balance and Say’s Law doesn’t function.
As Say put it, the reason some goods are not consumed is because other goods are not produced; there is insufficient effective demand. There may be want, maybe even extreme poverty, but that is not effective demand because the people in want are not producing anything to exchange for the goods they may desperately need to consume.
The problem becomes more acute as a few people become more productive, and more and more people produce nothing; every dollar (or euro) of production not spent on consumption but on more production makes the problem worse. The real “paradox of thrift” is not that it is good for individuals to save but bad for governments (until you have tens of trillions in unserviceable debt?), but that the wrong kind of thrift practiced by the many increases the wealth of the few.
 |
| Harold G. Moulton |
That is the problem with the German proposal, aside from the fact that the cash handed out to children would not be withheld from their own production but consist of redistributing the cash — production — of others. The proposal reinvests profits instead of consuming them, and then not even for the primary benefit of the savers but for the borrowers of the savings. This reduces effective demand and makes the likelihood that the new investment (remember: savings equals investment . . . just not necessarily for the saver) will not be as profitable, or perhaps not profitable at all.
Massive saving creates what Dr. Harold G. Moulton called “the Economic Dilemma.” As he explained it in his 1935 book, The Formation of Capital, “The dilemma may be summarily stated as follows: In order to accumulate money savings, we must decrease our expenditures for consumption; but in order to expand capital goods profitably, we must increase our expenditures for consumption.” (Harold G. Moulton, The Formation of Capital. Washington, DC: The Brookings Institution, 1935, 28.)
Fortunately for Germany and other nations with high rates of personal savings such as Japan, they have been able to make up the deficit in domestic demand by exporting “excess” production, mostly to the United States. With the chaos being spread throughout the global economy by President Trump’s economic and tax policies, however, there is a very real possibility that saving countries will no longer be able to rely on export demand by dissaving countries.
If President Trump succeeds in limiting or even eliminating foreign imports from the U.S. economy, the results would be disastrous, and not just for German children. Productive capacity cannot be created by fiat, executive order, waving a magic wand, or even imposing tariffs that drastically reduce domestic purchasing power — effective demand.
John Maynard Keynes
By reducing effective demand, Trump’s tariffs would essentially kick the U.S. economy in the teeth, stomp it into the ground with spiked boots, and beat it into jelly with a club, for it is consumption, not production that drives economic growth. Tax cuts for the wealthy don’t solve the problem but make it worse. This is because tax cuts for the wealthy allows them to produce gargantuan amounts of goods and services that no one domestically has the balancing production to purchase, and foreign countries will not purchase it in retaliation for the tariffs.
As for the Keynesian solution of creating money backed by government debt to solve the problem by stimulating demand . . . that hasn’t worked for nearly a century now, so we should increase it? $35 trillion in unserviceable debt isn’t enough? The U.S. credit rating is already going down. Do we want to destroy it forever? No, the way to solve the problem of overproduction by the rich and underconsumption by the non-rich is not to “multiply barren consumptions” as Say put it, i.e., creating money not backed by the present value of existing and future production.
Louis O. Kelso
The way to solve the problem is not to make the rich more productive, but to make the non-rich more productive. With the fall in the economic value of labor as technology advances, that will not be by “creating jobs.” It will be by making it possible for ordinary people without existing savings to purchase productive technology. They will then become productive as owners of capital in addition to, or instead of, as owners of labor.
This will not be by saving or redistributing existing wealth as the German plan proposes. As noted, that simply makes the problem worse by diverting consumption power into production.
No, as Louis O. Kelso explained well over half a century ago as the first cracks were appearing in the post-war (WWII, that is) pseudo free market, the only real solution is to make it possible for “the rest of us” to purchase equity shares of sound companies representing newly formed growth capital using newly created money. They can repay the money with the future profits of the capital itself. Instead of traditional collateral, people can use capital credit insurance to repay the loan in the event of default.
This is the proposal embodied in the Economic Democracy Act. Instead of imposing tariffs, redistributing existing wealth, sponsoring counterproductive savings plans, or anything else, legislatures throughout the world should adopt the EDA immediately if not sooner.
#30#
