Tuesday, January 03, 2006
Since “the curse of compounding” is a difficult concept to understand, it would probably be helpful to construct an analogy to which most people could relate.
The national debt has been compounding in excess of its effective interest rate, and this means that the government is essentially borrowing the money to pay the interest on the national debt. In other words, even though the interest payments are being made, the overall debt continues to increase.
This is similar in practice to a person who uses one credit card to make the payments on another. Even though the minimum payments are in fact being made, this person is actually making these payments with additional debt, and thus the overall balance continues to increase.
When the credit limit on one card has been reached, this person then applies for an increased credit line. When those requests are eventually denied, this person will either apply for a new credit card or employ a complex system of balance transfers, cash advances, and creative accounting to keep the whole scheme afloat. Meanwhile, the finance charges just keep growing and growing.
Eventually, a point will be reached when all available sources of borrowing have been exhausted, and this person will then be faced with the monumental task of paying back his accumulated debts. However, the debt will likely have grown so large that this person will hardly be able to make the minimum payments, and bankruptcy will become an inevitable conclusion.
Likewise, the government continues to borrow more and more money, and is now so desperate for cash that it has started borrowing money from the communist country of China. Assuming that the government was suddenly and miraculously able to balance the budget, the interest charges on the national debt would amount to 28% of available tax revenue, and this says nothing of repaying the underlying debt.
Would the person in the previous analogy be able to repay a debt whose finance charges had grown to 28% of his net income? How could he possibly afford such enormous interest payments when he could not even manage to live on his full income in the first place?
Think about it.
