Okay. Welcome back to Gary's Economics.

Today we are going to explain compound interest.

Okay.

So compound

interest is a very popular topic on social media,

especially the financial influencer space.

Famously, Albert Einstein is

said to have called compound

interest the most powerful force in the universe.

He probably didn't really say that.

What else

are you misunderstanding about compound interest?

Okay, we should probably start

with a very clear explanation

of what compound interest is, why it's so popular,

and why it's a big deal,

why Albert Einstein allegedly

thought it was so important.

So the big thing about compound interest is that it

grows in what mathematicians

would call an exponential fashion.

And we're going to show you

how that works very quickly

in a very simple explanation.

So let's assume you have a really good investment

and you're able to make 10% a year,

which is a very high rate of return.

Let's say you start with £1,000.

In your first year

you will get given £100

in interest, let's say puts you to £1100.

But in the next year, since you not only get 10%

on your initial £1000, but also this £100, you end up

seeing your £1100 go up by not just £100,

but £110, which is of course more,

which means you end up with £1210 and this process

increases each time.

So next time you...

this goes up by 110 plus another 11.

So you end up getting 121.

And just this just keeps happening basically.

Every single year,

not only does your investment go up,

but your growth increases as well.

What this means is because the growth each year

is increasing,

it means that if we imagine your wealth

over time, so here's how old you are.

Here's how rich you are.

It doesn't just go up in a straight line

like this dotted line.

It actually goes up in this curve exponential way,

which kind of curves upwards, you know, to the moon,

some would like to say.

And this is the reason why

compound interest is so appealing.

It gives the sense

that if we just save enough year

after year,

we'll grow more and more and more

and our wealth will shoot upwards towards the moon.

And this is the

reason why compound interest is so popular, basically.

And it's super,

super attractive and it's super compelling.

And this is why a lot of financial influencers

will say,

save your money year after year,

build up your compounding interest.

We can all see our savings go to the moon

and we can all be spectacularly rich.

That is the power of compound interest.

And behind this is an idea about society

and an idea about the economy, which is basically true.

So why is it that you can make these kind

of growing returns year after year?

What is happening

in theory, in the economy

that allows these exponential, rapidly growing returns?

This idea is probably best explained by imagining,

and economists love to do this,

and I think it's often quite unrealistic,

imagining your sort of desert island economy.

So you arrive on a desert island.

There's nothing there.

You know, you're struggling to survive.

What do you do?

Well,

the first thing you need to do is you take care of your

food supply. So you, you

build a kind of farm in your first year.

And then because you've set up

the sort of basics of a farm, that means that next year

you have more food,

which means you have an extra bit of time

which you can use to build a better house,

and you can use to build better tools.

And then each year,

because you're improving your productive capacity

every single year,

you have a bit more free time and a bit more resources,

which you can

then use to build

your productive capacity again and again and again.

So the kind of compound interest that we are seeing

from an individual

perspective is mirrored

by this kind of compounding returns in society.

Because each year

as you build things up, you have more resources,

and you can use those extra resources

to build more resources again.

And that is why the compound interest

that we see as individuals when we save

can also be mirrored in ideas such as economic growth,

because each year you have more resources.

If you put those extra resources in as well,

you can grow even faster each successive year.

And these ideas, these ideas about compound interest,

they're really, really appealing

to a certain kind of person.

And to be honest,

I am that certain kind of person, this kind of non

busy shopkeepery person that likes this idea,

if I work hard every year,

if I save a bit

every year, I can get more

and then the growth will grow

and then the growth will grow on top of that.

And eventually if I just work hard every year

and save every year, I'll get richer.

And in the long run, I'll be rich.

It's a super compelling

and it's a super appealing idea.

There's only one problem with that idea,

it doesn't work.

And what I'm going to explain in

this video

is why it doesn't really work for individuals,

and why it doesn't really work for society.

So I think you should be able to see relatively quickly

when it doesn't work

for individuals,

by simply comparing the story of compound interest

with the reality of economic life in our society.

So you see this graph that I drew for you,

you have compound interest

just going up and up and up to the moon.

It gives this kind of implication

that as long as you save every year,

as long as you wait long enough,

you'll get richer and richer and richer

and richer, and by the end you'll be a millionaire.

The big question I have is,

I think,

probably the big tell,

that this doesn't really work like this.

If it's so easy to become a millionaire,

why is such a small minority of people

actually millionaires?

Is it because they're lazy?

Is it because they're not saving?

Is it because they're spending too much money?

Or is the reality

a little bit more complicated than that?

So the big reason why this idea

of continually compounding returns doesn't work

is because it ignores what economists would call

the life cycle nature of savings.

So most people only work for a period of their lives.

Most people

increasingly nowadays study up until they're 21,

and they hope to retire when they're sort of 60, 65,

and they work for this 45 year period.

This means that you can't do this

saving and compounding for your whole life.

You have two periods, one at the beginning

and one at the end,

where you're not working.

And during those periods where you're not working,

what is happening to your compounding?

Well, essentially, it's working in reverse.

When you’re young and you're a student, you're not...

you're not earning any money

and you're having to pay to go to university.

And when you are old and you're retired,

you're also not earning any money.

And you increasingly have really

pretty large running costs

in terms of paying your bills, paying for your,

just your regular needs.

But as you get older, increasingly

a lot of people are having to spend a lot of money on

caring as they get old and end of life care.

That basically means that the actual graph of wealth

over time looks quite different.

So let's draw that graph again.

Here's how rich you are.

Here's your age.

What does it really look like?

Well, first of all, you don't start at zero.

You start down here.

You've got to pay off your mortgage,

you've got to pay of your student debts.

Then you start saving.

Well things happen.

You have your first kid.

That definitely cost you a bit.

You have your second kid.

Now you're making a bit more because you're old.

Now you retire. Well, what happens when you retire?

Suddenly you start needing this money

to get you through your retirement.

You start to get sick.

You need a carer.

You need to be in a home.

And by the time you die,

most people are back around zero.

And this is what happened to my grandparents.

They all owned property when they were alive.

They’d

all basically lost

all of that wealth by the time they died

because while you might have thought

you were saving up and going to the moon,

what most people are actually

doing is just saving up enough

to survive their retirement.

So if I look at my family

and I think this is very common

for British families or families overseas,

all of my grandparents

actually were able to own property

at some point in time.

But because they incurred

so many costs in their later

life, paying for their time

and paying for their end of life care,

they basically ended up dying with nothing.

So what you think you are seeing as compound growth

is actually really just

what we would call as economists,

the life cycle saving.

And you

as a family are not really accumulating

anything over time.

And the second reason

why it doesn't really work

for individuals is quite simply, increasingly

for a big chunk, maybe even a majority of workers.

They're quite simply is almost nothing left over

after paying your regular cost of living.

As rents,

energy and food get more expensive and wages

don't keep up,

more and more people are ending up in a situation

where basically they have nothing left to save.

And this is a double problem, right,

because firstly,

if you can't save anything,

you can't get these compounding interests.

And secondly,

once you understand the previous point

about life cycle saving,

you realise that you need

this accumulated compound interest

that you've accumulated over the course of your life

to pay for your retirement.

So what we have is a situation now.

Many working people can't

afford to accumulate these compound interest at all

because they can't save.

And that means that their retirements are increasingly

completely unfunded, which is a big problem.

But how does that map in to this idea,

which I introduced at the beginning,

which is the reason that individuals

can compound their interest and get growth upon growth,

upon growth,

is because society can compound its interest

and getting growth upon

growth, upon growth, by building more and more

and more productive capacity year

after year, and creating more production

and more free time to continually compound

growth as a society.

If societies can grow in a compounding way forever,

why can't individuals

grow in a compounding way forever?

And once again,

we can realise this difference between the theory

and the reality by basically

looking at what's happening in real life.

Which is just like in the individual case,

the theory tells us compound

interest can make us all rich over time

and yet in reality, very, very few people

ever do become

even millionaires, never mind billionaires.

The theory tells us that

economic growth can compound forever

in an economy, in a society,

we can make increasingly richer economies,

and yet we increasingly live in economies

which struggle to get even 1% economic growth.

Why is that?

And the reason for this is basically that we live

in economies that have

physical limits.

And I think the clue in a way, should have been

that the example which we used to introduce

to the idea of

compounding societal growth was a desert island.

Well, what are the key features of a desert island?

The key feature of a desert island

is that it's completely uninhabited, completely wild.

There's a tonne of natural resources,

and nothing is built on that island.

Now, if you land on an island like that,

especially if it's a large

island with tonnes of natural resources,

you really can grow as a society in a compounding way

because there's this enormous island

for you to expand into, and you can build up

one area of the island,

you can industrialise one area of the island.

You can use the tools that you can build in that area

to expand to the next area

and to expand to the next area,

and to expand to the next area

and to expand to the next area.

The problem you have

is that eventually

you will get to the other side of the island,

and you will have nowhere to expand into.

So what do you do when your model is

built on rapidly expanding growth

and you hit the end of your island?

Well, this causes a problem, right?

Because we have individuals in society

and we have individuals in our society

who are extremely wealthy.

They own much of the natural resources.

They also have a lot of productive equipment,

like they might have factories,

or they might have farms or they might have mines.

And these guys will see their wealth grow

at about 4%, 5% a year.

And that's not really a problem

when you live in these infinite societies,

because I can own this part of the country

and I can grow it,

and I can grow it, and I can grow it,

and you guys can just keep moving out to new

parts of this island.

The problem happens is when you get to the end.

I'm going to keep growing

and you guys are going to have nowhere to go.

And what happens in that situation?

Well, in that situation, what you will often see

is the economic growth

of the whole society will fall significantly.

Just like now we are, I'm talking to you from the UK,

which is a very old economy, it's

a very industrialised economy,

it industrialised a long time ago.

Pretty much

all of the island is owned,

pretty much all of the island is used.

There's not really anywhere in Great Britain

where you can go

and live

off of the land,

because all of the land is owned and used and

that means it's not

super easy and super obvious to grow,

because you have this question of where do you grow to?

Where do you grow into?

That means that the growth of the country

has dropped down to only 1% now,

and yet growth of the wealth of the rich

is still around about 5% kind of level.

And this is the key difference,

which I really want you to understand.

Economic growth in the UK is 1%.

Even in bigger countries

like the US, it's 3% where they have more growth.

The rich are growing their wealth at 5%.

This is a lot bigger.

5% is a lot more.

So if the rich are growing at 5%,

the economies are growing at 3% or maybe even 1%.

Where is this wealth coming from?

Because I think it's very tempting

when we

look at growing wealth of individuals,

growing wealth of individuals to think, well,

this individual is a very productive individual.

He's creating more productive things for our society.

He's helping our society grow.

But I don't think that actually maps

onto the

real lived situation of being a wealthy person.

So I am a moderately wealthy person.

I'm not a billionaire.

I'm not Elon Musk,

but I'm rich enough

that I can live off of my passive income,

which basically means

I can live off the income of the wealth that I own.

And when I made that wealth,

which is in my sort of early to mid 20s,

I had a lot of choices about what investments

I was going to make.

And at that point, I realised that not

all investments are about creating

new productive capital or

creating new productive machinery.

You have an alternative option as well,

which is you can buy existing investments

or you can lend money to other people,

put other people into debt, essentially.

And I made the variety of investments,

I did invest into productive companies

that were trying to make productive stuff.

And I also invested

into just buying a lot of existing assets.

I bought stocks, I bought property,

I bought gold, I did a bit of both things

now because I made that money

in the early 2010s, when it was a very weak economy.

Most of the productive investments

that I invested in basically failed,

and they failed because

essentially there was a very weak consumer.

You know,

I invested in some restaurant

chains and things like this,

and there were no customers, so these things failed.

But the investments I made or I simply bought existing

assets, bought existing

stocks, bought existing properties,

bought existing

gold, these investments all did really, really well.

And I think this thing that happened to me,

where I made a lot of money

and I tried to grow the economy and basically failed

and discovered

that what works is buying existing assets,

shows you exactly the problem with compounding interest

in finite economies in finite countries

on a finite planet.

If you

allow the rich to grow

and grow and grow and grow and grow,

once you hit your natural limits,

the rich will continue to grow by

basically cannibalising the existing middle class.

And that's not because they're evil,

it's simply

because their wealth is so large and grows so quickly,

and there are so few actual

real investment opportunities

that basically they have no other option.

And if you think about it,

this is also why it can't work for the individual.

You know, it's...

we live in a finite country.

We live on a finite planet.

There's only so much you can grow by expanding

and expanding and expanding.

Eventually you reach your limits,

and once you reach those limits, what used to be

a kind of everybody wins game where we expand,

we expand,

we grow

becomes a competition for the existing resources.

The rich will bid up the natural resources.

They will increasingly buy

and own the natural resources,

they will increasingly monopolise

important societal resources,

like not just like farmland,

but also we're obviously seeing

the rich monopolising things

like ownership of social media,

ownership of physical media,

ownership of productive machinery, things like this.

And over time,

they will simply squeeze the middle class out.

And you kind of reach this,

I suppose, what some people call late stage

capitalism, where we've already expanded a lot.

There's not a lot of obvious space to expand into.

Everything is owned,

and suddenly it starts to be a competition

for who is going to own the existing resources.

And that is a problem, because if you reach that point

and you have a small amount of people

who are extraordinarily rich,

it will be very easy for them to outcompete

the weaker players for those existing resources.

And that is what we're basically seeing now.

We are seeing the very rich growing their wealth at 5%,

while the economy grows at just 1%.

And the way that that is happening is essentially

the rich are eating your cake,

the rich are taking your assets.

And this is why the assets that you own

will not be owned by your kids,

will not be owned by your grandkids.

It is why your kids and grandkids will probably own

nothing and be extremely poor

and probably quite unhappy.

This is what happens when you allow compound interest.

The rich eventually eat the middle class.

And I think one thing

that is interesting about this dynamic is

what you first see when it first starts happening,

when the rich start struggling to actually expand

and start

instead focusing on buying the existing resources.

The first thing that you see when that happens is

asset prices, existing asset prices start to rise.

At most people...

for most people,

the most visible asset price is housing.

So they all see the house price rise.

But it won't just be house price.

You also see

land prices

going up, stock prices going

up, the gold price going up.

Even things like classic cars and classic art,

all of these asset prices will rise.

And what you are seeing

there is kind of the dispossession

of the middle class

and the driving of the middle class into poverty.

But because these middle class people own assets,

they very often

see those asset prices rising and think, this is good,

we're getting rich.

And really, what I want to do in this video is ring

the alarm bell and say,

when you see those asset prices rising,

that is not you getting rich.

That is your class, your group of people,

ordinary families losing your assets.

And it is your kids and your grandkids

being driven into poverty.

I'm always reminded when I see, you know,

ordinary people

happy about house price rises of, a Bible story,

trying to get more Bible stories into these videos.

There's a story in the Old Testament

about two sons, called Esau and Jacob.

Esau is the eldest son,

so he's the person who should inherit the,

the land of the father

according to the rules at the time.

He's a big, strong guy,

likes to go hunting, but he's a bit stupid.

He goes out

hunting one day,

he gets lost,

he comes back late and he’s starving hungry.

And his younger brother

Jacob says to him, “Listen, I can see you’re hungry,

I'll give you this little bowl of food that I've made.

If you give me your inheritance.”

And the older son says,

“Well, I'm not going to get my inheritance

for another 40, 50 years, like, f**k that,

that's a long time away.

I'm hungry, give me the food.”

And the end result is

that Esau kids and Esau's grandkids will be poor.

That is what is happening now.

That is what is happening now.

The rapid compound interest growth of the very rich

is driving

your family out of the ability to own assets.

That means in the long run,

not just your kids and your grandkids,

but your whole community

will not own assets in 40, 50, 60 years.

That means you will have no middle class.

If you have no middle class, then

you have nobody to drive spending.

You have nobody to drive economic growth.

And if you want to see what a country looks like

when it has a very small middle class,

you can see that, go to India, go to Brazil,

go to Johannesburg in South Africa, countries

with no middle class

generally provide

extremely low quality

of economic life for ordinary people.

And if you think that can't happen in this country,

go read

Charles Dickens

because it happened here 100 years ago

and it can easily happen again.

So to conclude,

compound interest,

it feels like a route out of poverty for everyone.

In reality,

it is the exact way

that the rich outbid you and your kids for resources.

Compound interest will lead to the rich

eating the middle class and poverty

for your kids and grandkids.

The only way to fix this is to change the tax system,

to stop taxing ordinary people

so much, and tax the super rich more.

If we do that, we can improve economic conditions.

If we don't do that, there will be poverty.

More and more poverty in this country.

Fight back, change the tax system, reduce inequality.

It's the only way to avoid poverty.

Thank you for your support.

Send this to your friends, send it to your mum.

Take care.