Why aren't we all getting rich from compound interest?

Summary

In this enlightening video, Gary from "Gary's Economics" delves into the commonly misunderstood concept of compound interest, often lauded as the ultimate wealth-building tool. While financial influencers frequently praise its exponential growth potential, Gary argues that the practical realities of life cycles and economic systems mean that compound interest doesn't allow everyone to become rich. He explains that the rich continue to grow wealth at the expense of the middle class due to finite resources and economic structures favoring the wealthy, leading ultimately to increased inequality and poverty unless systemic changes are made, particularly in taxation.

Highlights

• Albert Einstein's misattributed quote on compound interest as a powerful force mocks its misunderstood societal view. 🎙️
• Compound interest relies on exponential growth, but many don't get rich because life circumstances prevent consistent saving. 📉
• The analogy of a desert island economy helps illustrate how initial expansion is possible, but limits are inevitable. 🏝️
• Economic systems favoring the wealthy ultimately mean they 'cannibalize' the middle class's resources, worsening inequality. 🏛️
• Without intervention, such as tax reforms, the concentration of wealth could erode the middle class, leading to further poverty. 🛑

Key Takeaways

• Compound interest is often misunderstood as a guaranteed path to wealth, but real-life economic constraints limit its effectiveness for most. 💸
• The concept of life cycle saving explains why individuals can't continuously benefit from compounding wealth due to periods of non-working life like education and retirement. 🏖️
• Finite resources in economies mean that the rich can often grow wealth at the expense of others, leading to widened economic inequality. 🌍
• The reality of rising living costs outpacing wages prevents many people from saving enough to benefit significantly from compound interest. 📈
• To combat economic disparity, systemic changes, such as tax reform to target the super-rich, are essential. 🔧

Overview

Gary's Economics takes on the behemoth topic of compound interest, often lauded in the financial world for its supposed magic. Gary tackles this concept by explaining its mathematical roots in exponential growth, debunking the myth that it's a universal key to wealth. The catchy notion of 'money on money' falls flat for most, due to economic limitations and life cycle realities, as Gary wittily explains.

With creative examples like the desert island analogy, Gary elucidates how our dreams of limitless growth clash with the stone-cold reality of finite resources and societies rigged for the wealthy. As he zooms out to the macro level, he points out that economies built for perpetual expansion hit walls—the wealthy flourish, but at the common folk's cost.

Gary's ultimate call-to-arms is for systemic tax reform, warning that the unbridled growth of wealth among the rich amid stagnant economies spells doom for the average Joe. He implores viewers to recognize the perils of unchecked economic inequality, advocating for fairness in tax policies that could bridge the gap and stave off a nation enmeshed in poverty.

Chapters

• 00:00 - 00:30: Introduction to Compound Interest The introduction of the chapter begins with a brief overview of the significance of compound interest in social media and financial circles. Albert Einstein is often quoted regarding its importance, although this attribution is likely incorrect. The chapter aims to clarify common misconceptions about compound interest, highlighting its popularity and influence. Future sections will delve into a clear explanation of what compound interest actually is, its appeal, and its significant impact in finance.
• 00:30 - 01:00: Exponential Growth of Compound Interest This chapter discusses the concept of compound interest and its exponential growth, as famously noted by Albert Einstein. It explains the process using a simple example: starting with an investment of £1,000 at an interest rate of 10% per year, where the first year yields £100 in interest, demonstrating the potential for significant financial growth over time.
• 01:00 - 01:30: Continuing Growth Process of Compound Interest This chapter explains the process of compound interest, where not only the principal amount but also the accumulated interest from previous periods earns interest. The narrator gives an example starting with $1,000 earning 10% interest yearly. In the first year, the interest is $100, making the total $1,100. In the second year, interest is calculated on $1,100, not just the $1,000 principal, leading to $1,210. This demonstrates how compound interest grows faster than simple interest as the interest itself accumulates and begins earning more interest.
• 01:30 - 02:00: Appeal and Misunderstanding of Compound Interest The chapter explores the concept of compound interest, highlighting how investments grow over time through the mechanism of increasing returns each year. Unlike a linear progression, compound interest results in exponential growth, illustrating that both the value of the investment and the rate of growth increase simultaneously over time. This concept is depicted by comparing the actual growth curve with a simple linear growth to underscore the power and appeal of compound interest in wealth accumulation.
• 02:00 - 02:30: The Economic Theory Behind Compounding Returns The chapter discusses the concept of compounding returns in economics, emphasizing its appealing exponential growth pattern. The transcript highlights how compound interest generates upward growth over time, leading to significant wealth accumulation. This concept is often promoted by financial advisors who encourage saving due to its compelling and attractive nature for building wealth.
• 02:30 - 03:00: The Reality of Savings Life Cycle The chapter, titled 'The Reality of Savings Life Cycle', focuses on the concept of compound interest and its impact on savings. It highlights the potential for exponential growth in savings over time, emphasizing the theoretical underpinnings of economic and social dynamics that enable these growing returns annually. While the promise made is that everyone can become 'spectacularly rich' through this phenomenon, the chapter begins to explore the fundamental ideas that allow such returns theoretically.
• 03:00 - 03:30: Challenges of Saving and Compounding Interest The chapter discusses the challenges of saving and the concept of compounding interest using an imaginative scenario. In the desert island economy analogy, an individual prioritizes establishing a food supply by building a farm. By setting up these basic resources, the person can produce more food the following year, illustrating the idea of initial investments leading to increased returns over time. This scenario connects to the broader economic principle of how initial efforts or investments can yield compounding benefits, emphasizing the importance of saving and forethought in economic planning.
• 03:30 - 04:00: Limitations of Economic and Individual Growth The chapter discusses the concept of limitations in both economic and individual growth. It illustrates how both individuals and societies can improve productive capacities over time by using resources more effectively. This is akin to compounding interest, where each year brings more resources and free time, allowing for further building of productive capacity, thus creating a cycle of growth.
• 04:00 - 04:30: Wealth Growth vs. Economic Growth The chapter titled 'Wealth Growth vs. Economic Growth' explores the concept of compound interest and how it can drive both personal wealth growth and broader economic growth. By reinvesting additional resources each year, individuals and economies can experience accelerated growth over time. The idea of compound interest is particularly attractive to certain individuals, as it suggests a self-perpetuating cycle of increasing resources and wealth.
• 04:30 - 05:00: Finite Economies and Wealth Accumulation The chapter titled 'Finite Economies and Wealth Accumulation' challenges the common belief that hard work and consistent saving will inevitably lead to wealth and financial growth. Despite its appeal and the logical sequence of working hard, saving, and eventually growing rich, the chapter claims this notion is flawed and seeks to explain the problem with this traditional view on wealth accumulation.
• 05:00 - 05:30: Ownership and Competition in Finite Economies The chapter discusses the limitations of ownership and competition within finite economies, emphasizing their inefficiencies for both individuals and society. It critiques the conventional wisdom of compound interest and perpetual economic growth, suggesting the need for a reevaluation of economic principles. Through graphical representations, it contrasts the linear growth assumption with the complex reality of economic life, urging readers to reconsider how economic success is traditionally measured.
• 05:30 - 06:00: Consequences of Rising Asset Prices This chapter discusses the misconceptions around the ease of becoming a millionaire amidst rising asset prices. It questions why, if wealth accumulation is supposedly simple, only a small minority of people actually achieve millionaire status. The chapter explores common assumptions such as laziness, excessive spending, and lack of savings, ultimately suggesting that the reality is more complex than these explanations.
• 06:00 - 06:30: Historical and Future Impact on Middle Class The chapter explores the concept of continually compounding returns and its limitations in the context of individual savings over a lifetime. It emphasizes the life cycle nature of savings, where individuals typically spend many years in education, starting work around age 21, and aim to retire by 60 to 65, giving them approximately 45 years of working life to accumulate savings.
• 06:30 - 07:00: Conclusion and Call to Action In the chapter titled 'Conclusion and Call to Action', the author discusses the concept of saving and compounding throughout one's life, highlighting the two periods where one isn't working: at the beginning, typically during education, and at the end, typically during retirement. During these periods, the compounding works in reverse, meaning these non-working phases impact how much one can ultimately save and grow wealth. The author emphasizes the importance of recognizing these phases and planning accordingly to mitigate their effects on long-term financial health.

Why aren't we all getting rich from compound interest? Transcription

• 00:00 - 00:30 okay welcome back to Gary's Economics Today we're 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 Um he probably didn't really say that What else are we 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
• 00:30 - 01:00 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
• 01:00 - 01:30 1,100 But in the next year since you not only get 10% on your initial 1,000 but also this 100 you end up seeing your 1,100 go up by not just 100 but 10 which is of course more which means you end up with 1,210 And this process increases each time So next time you this goes up by 110 plus another 11 So you end up going
• 01:30 - 02:00 one to one 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
• 02:00 - 02:30 up in this curved 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 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 Um and this is the reason why compound interest is 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
• 02:30 - 03:00 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
• 03:00 - 03:30 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 supplies 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
• 03:30 - 04:00 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 these kind of compounding returns in society because each year as you build
• 04:00 - 04:30 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
• 04:30 - 05:00 honest I am that certain kind of person this kind of numbersy 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 rich 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 the idea It doesn't work And what I'm going to explain in this
• 05:00 - 05:30 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 that 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 of compound interest just going up and up and up to the moon Um it gives this kind of implication that as long as you save every year as long as you wait long
• 05:30 - 06:00 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
• 06:00 - 06:30 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 Uh and they hope to retire when they're sort of 60 65 and they work for this 45
• 06:30 - 07:00 year period Uh 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 earning you're not earning any money
• 07:00 - 07:30 and you are 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 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
• 07:30 - 08:00 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 got to pay off your mortgage You got to pay off 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 Um now you're making a bit more cuz you're old Now you retire Well what happens when you retire Suddenly you start needing this money to get you
• 08:00 - 08:30 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 to survive their retirements 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
• 08:30 - 09:00 able to own property at some point in time but because they incurred so many costs in their later life paying for their retirement 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 economist 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
• 09:00 - 09:30 for a big chunk maybe even a majority of workers there quite simply is almost nothing left over after paying your regular cost of living As rent 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 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
• 09:30 - 10:00 you realize 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 as a situation now many working people can't afford to accumulate these compound interests 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
• 10:00 - 10:30 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
• 10:30 - 11:00 realize 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
• 11:00 - 11:30 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 you the idea of compounding societal growth was a desert island Well what are
• 11:30 - 12:00 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 ton 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 tons 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
• 12:00 - 12:30 one area of the island You can industrialize 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
• 12:30 - 13:00 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 four five% a year
• 13:00 - 13:30 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
• 13:30 - 14:00 the UK which is a very old economy It's a very industrialized economy Industrialized 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 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 go into That means that the growth of the country has
• 14:00 - 14:30 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 is 3% where they have more growth The rich are growing in their worlds at 5% This is a lot bigger 5% is a lot more So if the rich are going at 5% the economies are growing at 3% or maybe
• 14:30 - 15:00 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
• 15:00 - 15:30 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 was in my sort of early to mid20s I had a lot of choices about what investments I was going to make And at that point I realized that not all investments are about creating new productive capital creating
• 15:30 - 16:00 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 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
• 16:00 - 16:30 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 where 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
• 16:30 - 17:00 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 cannibalizing the existing middle class
• 17:00 - 17:30 And that's not because they're evil is 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 um we live in a finite country we live on a finite planet Um there's only so much you can grow by expanding and expanding and expanding Eventually you reach your limits And once you reach
• 17:30 - 18:00 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 monopolize important societal resources like not just like farmland but also we're obviously seeing the rich monopolizing things like ownership of social media ownership of physical media ownership of productive machinery things like this And over time they will simply
• 18:00 - 18:30 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 out compete the weaker players for those
• 18:30 - 19:00 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
• 19:00 - 19:30 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 Um at most people for most people the most visible asset price is housing So they will see the house price rise But it
• 19:30 - 20:00 won't just be house price You'll 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 were seeing there is kind of the dispossession of the middle class and the driving of the middle class into poverty But because these middle-ass people own assets they very often see those asset prices rising and think "This is good We're getting rich." Um
• 20:00 - 20:30 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 a Bible story Trying to get more Bible stories into these videos
• 20:30 - 21:00 Um there's a story in the Old Testament about two sons uh called uh Esau and Jacob Esau is the eldest son So he's the person who should inherit the uh 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 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
• 21:00 - 21:30 me your inheritance And the older son says "Well I'm not going to get my inheritance for another 40 50 years." Like that That's a long time away I'm hungry Yeah Give me the food And the end result is that Esau's 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
• 21:30 - 22:00 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 which 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
• 22:00 - 22:30 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
• 22:30 - 23:00 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 is the only way to avoid poverty Thank you for your support Send this to your friends Send it to your mom Take care