7 ms·

Isn't the theory of compound interest sufficient to explain why the rich get richer faster than that poor get richer?

eru 3y ago
No, why? There's no single 'theory of compound interest'. First, the rich don't reliably get richer faster than the poor get richer. (Despite what the linked article or other texts might claim.) Second, interest rates are mostly an abstraction. Yes, if two people are both putting money in a bank account in the same currency, the one with the higher interest rate will get richer faster. In the real world, many investments yield a variable nominal rate of return (eg real estate, stocks, art, etc). And you also have to worry about factors like inflation or counter party risk.
- VirusNewbie 3y ago
  >First, the rich don't reliably get richer faster than the poor get richer. yes they do, as money printing benefits those who are leveraged into assets more than other types of debt holders. The rich (by proxy, through investing in the stock market) actually hold more debt in aggregate. And per capita, they hold WAY more debt, hence benefit from money printing even more. Money printing is indirect wealth transfer from everyone else to the rich.
  - eru 3y ago
    You seem to assume that creditors are a bunch of morons? Any inflation that's anticipated at the time a debt contract is made will be priced in to the debt contract. That's (part of) why high inflation economies have high interest rates. You can load up with debt as well: it's fairly easy to open up a margin account at eg Interactive Brokers, or (almost equivalently) to trade in options (which have margin financing sort-of built-in).
    - VirusNewbie 3y ago
      This is the most arbitraged thing in the world, as inflations are lagging indicators. Chart M2 growth to CPI and you can clearly see what I mean.
      - eru 3y ago
        > This is the most arbitraged thing in the world, [...] So we agree and you say that this thing is already priced in? Good. Yes, market participants anticipate many things, and make their contracts based on what they expect. Not on any mechanical considerations of what happened before.
    - pixl97 3y ago
      >You seem to assume that creditors are a bunch of morons? After 2008 and 'too big to fail', you don't?
      - eru 3y ago
        'Too big too fail' is mostly about taking advantage of (implicit or explicit) government guarantees. Ie making the taxpayer bail you out. That's very different from normal creditors being morons. (And yes, the people with resources often, but not always, have an easier time getting the government to give them even more resources.)
- robotresearcher 3y ago
  > the rich don't reliably get richer faster than the poor get richer. Given same rate of return, the one who puts in the most money gets richer faster, in absolute dollars. The article says that on top of this, those with more capital get better relative returns too. You don't refute this by just saying it's not so. The increasing wealth disparity we observe would seem to support this idea.
  - eru 3y ago
    Global inequality has declined in recent decades. (Mostly thanks to India and even more so China going from dirt poor to poor or middle income. But many other countries like South Korea or Singapore and previously Japan have also caught up. Poland and many, but not all, former Eastern block states have also done quite well.)
- HumblyTossed 3y ago
  > the rich don't reliably get richer faster than the poor get richer. Doubling 100M in 10 years to 200M is, IMO, getting richer faster than double 25K to 50K in 10 years.
  - steveBK123 3y ago
    Also the poor generally don't have wealth to speak of, definitionally. Having $25k or 50k in savings is quite far from being poor.
marcosdumay 3y ago
If any constant factor were sufficient, there would be no time period when the reverse happened, the modern economies would be in an impossible state.
schemescape 3y ago
I don’t see the logic there. If they both got the same interest rate, then their wealth would grow at the same rate. Add in progressive taxation and the gap might narrow. If they’re getting different rates and taxation is regressive, then those seem like better explanations. Edit: also spending patterns. Edit again: note that this wasn’t meant to be a complete explanation. I just wanted to point out a few reasons why compound interest is not sufficient to explain a widening wealth gap (the claim in the comment I responded to).
- foota 3y ago
  Well also, you can't benefit from interest if you don't have any money left over.
- adastra22 3y ago
  Interest returns (including ROI on investments) only help you if you have money in the market. The poor don’t. The poor are also disproportionately affected by inflation, as that causes wage stagnation, whereas regular old inflation is less than interest rates so it is built in protection for capital holders.
  - schemescape 3y ago
    Yeah, more great examples of why compound interest is not the only explanation.
- steveBK123 3y ago
  Low income spend a higher % of their income - therefore inflation is bad (rent/food/gas costs more). High income save & invest a higher % of their income - therefore inflation is good (their stocks go up). This isn't some sort of moral or judgmental statement. It's simple math. The more your income goes up over time, the less of a % is needed to cover the basics of food/shelter/energy.
  - jdhsvzhhgfr 3y ago
    Not quite. Inflation doesn’t make stocks go up Willy nilly, that’s outright silly.
vondur 3y ago
Not really. I was watching a video about how someone like Elon Musk won’t take a salary from their company. Instead they get paid in stock. Using the stock as collateral they take out loans at low interest rates based on how well the banks assume that the stock will perform. Then all of that money they have is non taxable. If the stock performance outpaces the interest rate, then even better.
- eru 3y ago
  Details depend on jurisdiction, and exact legal structuring. (Eg where I live, there's no capital gains tax, so someone like Elon Musk could just sell their shares without any extra taxes, instead of having to borrow against them.)
  - mrguyorama 3y ago
    They would probably still do that scheme, because it has the benefit of you never see the downside risk of stock. If the stock goes up, you can pay off the loan and keep the difference. If the stock becomes worthless, you can default and let the bank be stuck with trying to claw back funds from a bankruptcy. Notably, the rich do not have problems with "credit score", which never seems to apply to them.
    - eru 3y ago
      It sounds like you assume banks are run by morons that like losing money? And it sounds like you have no idea how borrowing against stocks works? First, the banks charge you interest depending on amongst other things the risk incurred. More risk, more interest. (Look at eg junk bonds for an example.) Second, when you borrow against your stock, you typically only get, say, 50 dollars loaned for every 100 dollars of stock. (Details vary.) If the value of your stock drops anywhere close to eg 75 dollars, typically the bank has the right to sell some or all of your stock to pay off the loan. If your stock dropped so quickly that it's gone before the loan has been paid off, the bank might or might not come after your other assets. Whether they can do so, depends on the contract you have with them. Again, if it's a non-recourse loan, you are going to pay higher interest, and they'll demand more conservative loan to value ratios. > If the stock goes up, you can pay off the loan and keep the difference. Third, why would you pay off the loan, and with what money? The whole point of the scheme is to never sell stocks, so you never have to pay capital gains taxes. You just let your loan's balance accumulate over time with the compound interest. (One popular scheme is called 'buy-borrow-die': because of a quirk in the US tax system, you don't pay capital gains taxes when you die. So you acquire stock somehow, then borrow against it, and you pay off the loan only when you die: your estate or the bank sells enough stocks to cover the loan, and doesn't have to pay capital gains taxes.) The banks are happy to let you run up a balance, as long as your loan-to-value ratio stays low enough. Ie as long as your stocks grow sufficiently faster than your outstanding loans. > Notably, the rich do not have problems with "credit score", which never seems to apply to them. Credit scores are a standardised system to deal with average people. If you are rich enough, the bank can afford to have a real human look into your specific situation, instead of relying on a number. As as a slightly made up example: Elon Musk is known for getting into legal fights and being annoying to deal with, and trying to wiggle out of obligations. So creditors might charge him more interest purely for that risk. Whereas Michael Bloomberg always stick so this agreements, and a handshake from him is a firmer commitment than an thousand page contract with Elon Musk that covers all eventualities. Paradoxically, someone who is known to to be able to afford expensive and competent lawyers might have to pay higher interest rates than some middle class Joe Average. It's not that the bank thinks Elon Musk has a higher risk of running out of money than Joe Average; but it's that the bank fears that Elon Musk is harder to sue than Joe Average is to foreclose on.
Xeoncross 3y ago
Compound interest includes both value inflation from governments printing money and actual earnings/payments from assets. Owning something that earns while you sleep does tend to increase you ability to focus on what is important. Sadly, I'm not sure anyone who is wealthy has what I would call a focus on what is important. Terrible situations, failed marriages, relationships with kids, etc..
mistrial9 3y ago
in the first year of covid-19 in the USA, millions of small business people on Main Street had serious impacts or simply closed, worse for common employees. Yet in that same year, the net worth of the top 5 wealthiest individuals in the USA (carefully watched on Bloomberg terminal and elsewhere) increased a LOT. Famously Elon Musk in particular. How does "compound interest" explain that?
pmorici 3y ago
In the US, where the majority of wealth is self made and not inherited, I’d guess that it is a function of IQ. Smarter people just make better decisions with their money on average. Edit: for those that doubt [0] [0] https://www.sciencedirect.com/science/article/abs/pii/S0160289607000219 https://www.sciencedirect.com/science/article/abs/pii/S01602...
- shmageggy 3y ago
  From the abstract of your link: > Regression results suggest no statistically distinguishable relationship between IQ scores and wealth Stop spreading dangerous myths.
  - pmorici 3y ago
    It says that earnings are correlated with iq.
- deterministic 3y ago
  There is zero correlation between IQ and wealth.
ppeetteerr 3y ago
The argument being made is that compound interest is higher the wealthier you are.

eru 3y ago

No, why? There's no single 'theory of compound interest'. First, the rich don't reliably get richer faster than the poor get richer. (Despite what the linked article or other texts might claim.) Second, interest rates are mostly an abstraction. Yes, if two people are both putting money in a bank account in the same currency, the one with the higher interest rate will get richer faster. In the real world, many investments yield a variable nominal rate of return (eg real estate, stocks, art, etc). And you also have to worry about factors like inflation or counter party risk.

VirusNewbie 3y ago
>First, the rich don't reliably get richer faster than the poor get richer. yes they do, as money printing benefits those who are leveraged into assets more than other types of debt holders. The rich (by proxy, through investing in the stock market) actually hold more debt in aggregate. And per capita, they hold WAY more debt, hence benefit from money printing even more. Money printing is indirect wealth transfer from everyone else to the rich.
- eru 3y ago
  You seem to assume that creditors are a bunch of morons? Any inflation that's anticipated at the time a debt contract is made will be priced in to the debt contract. That's (part of) why high inflation economies have high interest rates. You can load up with debt as well: it's fairly easy to open up a margin account at eg Interactive Brokers, or (almost equivalently) to trade in options (which have margin financing sort-of built-in).
  - VirusNewbie 3y ago
    This is the most arbitraged thing in the world, as inflations are lagging indicators. Chart M2 growth to CPI and you can clearly see what I mean.
    - eru 3y ago
      > This is the most arbitraged thing in the world, [...] So we agree and you say that this thing is already priced in? Good. Yes, market participants anticipate many things, and make their contracts based on what they expect. Not on any mechanical considerations of what happened before.
  - pixl97 3y ago
    >You seem to assume that creditors are a bunch of morons? After 2008 and 'too big to fail', you don't?
    - eru 3y ago
      'Too big too fail' is mostly about taking advantage of (implicit or explicit) government guarantees. Ie making the taxpayer bail you out. That's very different from normal creditors being morons. (And yes, the people with resources often, but not always, have an easier time getting the government to give them even more resources.)
robotresearcher 3y ago
> the rich don't reliably get richer faster than the poor get richer. Given same rate of return, the one who puts in the most money gets richer faster, in absolute dollars. The article says that on top of this, those with more capital get better relative returns too. You don't refute this by just saying it's not so. The increasing wealth disparity we observe would seem to support this idea.
- eru 3y ago
  Global inequality has declined in recent decades. (Mostly thanks to India and even more so China going from dirt poor to poor or middle income. But many other countries like South Korea or Singapore and previously Japan have also caught up. Poland and many, but not all, former Eastern block states have also done quite well.)
HumblyTossed 3y ago
> the rich don't reliably get richer faster than the poor get richer. Doubling 100M in 10 years to 200M is, IMO, getting richer faster than double 25K to 50K in 10 years.
- steveBK123 3y ago
  Also the poor generally don't have wealth to speak of, definitionally. Having $25k or 50k in savings is quite far from being poor.

marcosdumay 3y ago

If any constant factor were sufficient, there would be no time period when the reverse happened, the modern economies would be in an impossible state.

schemescape 3y ago

I don’t see the logic there. If they both got the same interest rate, then their wealth would grow at the same rate. Add in progressive taxation and the gap might narrow. If they’re getting different rates and taxation is regressive, then those seem like better explanations. Edit: also spending patterns. Edit again: note that this wasn’t meant to be a complete explanation. I just wanted to point out a few reasons why compound interest is not sufficient to explain a widening wealth gap (the claim in the comment I responded to).

foota 3y ago
Well also, you can't benefit from interest if you don't have any money left over.
adastra22 3y ago
Interest returns (including ROI on investments) only help you if you have money in the market. The poor don’t. The poor are also disproportionately affected by inflation, as that causes wage stagnation, whereas regular old inflation is less than interest rates so it is built in protection for capital holders.
- schemescape 3y ago
  Yeah, more great examples of why compound interest is not the only explanation.
steveBK123 3y ago
Low income spend a higher % of their income - therefore inflation is bad (rent/food/gas costs more). High income save & invest a higher % of their income - therefore inflation is good (their stocks go up). This isn't some sort of moral or judgmental statement. It's simple math. The more your income goes up over time, the less of a % is needed to cover the basics of food/shelter/energy.
- jdhsvzhhgfr 3y ago
  Not quite. Inflation doesn’t make stocks go up Willy nilly, that’s outright silly.

vondur 3y ago

Not really. I was watching a video about how someone like Elon Musk won’t take a salary from their company. Instead they get paid in stock. Using the stock as collateral they take out loans at low interest rates based on how well the banks assume that the stock will perform. Then all of that money they have is non taxable. If the stock performance outpaces the interest rate, then even better.

eru 3y ago
Details depend on jurisdiction, and exact legal structuring. (Eg where I live, there's no capital gains tax, so someone like Elon Musk could just sell their shares without any extra taxes, instead of having to borrow against them.)
- mrguyorama 3y ago
  They would probably still do that scheme, because it has the benefit of you never see the downside risk of stock. If the stock goes up, you can pay off the loan and keep the difference. If the stock becomes worthless, you can default and let the bank be stuck with trying to claw back funds from a bankruptcy. Notably, the rich do not have problems with "credit score", which never seems to apply to them.
  - eru 3y ago
    It sounds like you assume banks are run by morons that like losing money? And it sounds like you have no idea how borrowing against stocks works? First, the banks charge you interest depending on amongst other things the risk incurred. More risk, more interest. (Look at eg junk bonds for an example.) Second, when you borrow against your stock, you typically only get, say, 50 dollars loaned for every 100 dollars of stock. (Details vary.) If the value of your stock drops anywhere close to eg 75 dollars, typically the bank has the right to sell some or all of your stock to pay off the loan. If your stock dropped so quickly that it's gone before the loan has been paid off, the bank might or might not come after your other assets. Whether they can do so, depends on the contract you have with them. Again, if it's a non-recourse loan, you are going to pay higher interest, and they'll demand more conservative loan to value ratios. > If the stock goes up, you can pay off the loan and keep the difference. Third, why would you pay off the loan, and with what money? The whole point of the scheme is to never sell stocks, so you never have to pay capital gains taxes. You just let your loan's balance accumulate over time with the compound interest. (One popular scheme is called 'buy-borrow-die': because of a quirk in the US tax system, you don't pay capital gains taxes when you die. So you acquire stock somehow, then borrow against it, and you pay off the loan only when you die: your estate or the bank sells enough stocks to cover the loan, and doesn't have to pay capital gains taxes.) The banks are happy to let you run up a balance, as long as your loan-to-value ratio stays low enough. Ie as long as your stocks grow sufficiently faster than your outstanding loans. > Notably, the rich do not have problems with "credit score", which never seems to apply to them. Credit scores are a standardised system to deal with average people. If you are rich enough, the bank can afford to have a real human look into your specific situation, instead of relying on a number. As as a slightly made up example: Elon Musk is known for getting into legal fights and being annoying to deal with, and trying to wiggle out of obligations. So creditors might charge him more interest purely for that risk. Whereas Michael Bloomberg always stick so this agreements, and a handshake from him is a firmer commitment than an thousand page contract with Elon Musk that covers all eventualities. Paradoxically, someone who is known to to be able to afford expensive and competent lawyers might have to pay higher interest rates than some middle class Joe Average. It's not that the bank thinks Elon Musk has a higher risk of running out of money than Joe Average; but it's that the bank fears that Elon Musk is harder to sue than Joe Average is to foreclose on.

Xeoncross 3y ago

Compound interest includes both value inflation from governments printing money and actual earnings/payments from assets. Owning something that earns while you sleep does tend to increase you ability to focus on what is important. Sadly, I'm not sure anyone who is wealthy has what I would call a focus on what is important. Terrible situations, failed marriages, relationships with kids, etc..

mistrial9 3y ago

in the first year of covid-19 in the USA, millions of small business people on Main Street had serious impacts or simply closed, worse for common employees. Yet in that same year, the net worth of the top 5 wealthiest individuals in the USA (carefully watched on Bloomberg terminal and elsewhere) increased a LOT. Famously Elon Musk in particular. How does "compound interest" explain that?

pmorici 3y ago

In the US, where the majority of wealth is self made and not inherited, I’d guess that it is a function of IQ. Smarter people just make better decisions with their money on average. Edit: for those that doubt [0] [0] https://www.sciencedirect.com/science/article/abs/pii/S0160289607000219 https://www.sciencedirect.com/science/article/abs/pii/S01602...

shmageggy 3y ago
From the abstract of your link: > Regression results suggest no statistically distinguishable relationship between IQ scores and wealth Stop spreading dangerous myths.
- pmorici 3y ago
  It says that earnings are correlated with iq.
deterministic 3y ago
There is zero correlation between IQ and wealth.

ppeetteerr 3y ago

The argument being made is that compound interest is higher the wealthier you are.