The gangster authority on time, Albert Einstein, supposedly remarked that compound interest is the eighth wonder of the world. 

Compound interest is in fact a powerful wealth builder. I remember in school having to do calculations to show how much money you would need to save with interest to become a millionaire. As an 11 year old, we were to be wowed by the prospect of one-million dollars (still a lot of money, but feels somewhat diluted as we’re now told this is not nearly enough for a proper retirement). It was used as a lesson to show how small savings over time add up big in the long run. Here’s a lesson from Dave Ramsey that is nearly identical to the one I was taught. 

The Ramsey article is from 2020 and it differs in one crucial way from my school lesson in the 1990s. Ramsey refers to investing whereas in school I was taught about saving. We did the calculations with a 7% interest rate and assumed it was money in a savings account. Now we get the same lesson, but the source of the return has been swapped from bank deposits to investing. I wish there was a word for when the undercarriage of conventional wisdom is swapped out, but we carry on as though nothing has changed. Galloway’s concern about the poor financial prospects of younger generations is clear in his work, so I find it out of place that he’s content to sing the praises of compound interest while glossing over this major change.

Saving has been taken away from you, but it’s not talked about because there’s a replacement: passive investing. You’ve likely heard this fact about the S&P 500:

The index has returned a historic annualized average return of around 10% since its inception through 2019.

So why am I complaining? Put your money in a lost cost index fund and you’ll still be a millionaire. It so happens that the growth of passive investing explodes as interest rates have fallen. In the first graph in the linked article you can see passive investing hockey stick from 2008 onward. It comes down to a key phrase you’ve likely seen many times but mostly ignored: “Past performance is no guarantee of future results.” If you buy a CD you know the yield at maturity, and it’s even insured against loss. No financial institution will make such a claim about an ETF, and in truth no one knows each year’s rate of return on the stock market. We’re supposed to accept as a matter of faith that among the positive and negative years, over time it adds up a particular return. 

Compounding through investing relies on infinite time horizons in a way that saving does not. In retirement there’s the “own your age in bonds” rule of thumb to protect against retiring during a recession, but in an environment with such low interest rates that means forgoing compounding interest in the name of capital preservation. Many pension funds assume 7% as their annual average rate of return. High quality corporate debt yields about 3% right now, treasuries even less. If you’re getting that hypothetical 10% return on your index funds but following the aged based bond/equity allocation rule, you drop below the 7% return rate after you turn 43 (43% bonds 57% equities). For comparison at a 2% bond yield you drop below 7% at 38. For you to make it to 65 without dropping below 7% average return, the bond yield would have to stay above 5.4%.

People aren’t marching in the streets because we’ve had a pretty powerful bull market for equities since 2008. Just as the average person came to hold passive vehicles, outside of a few episodes of turbulence, the performance has been steady, positive, and exceeding the compound returns of a bank account with a good APY. As we’ve switched our compound interest narrative from saving to investing, index funds have presented as good substitutes hiding from us what we’ve lost. But what happens if we get a stretch like we had from 2000 to 2002 where for three years in a row the return on the S&P was negative? In 2001, passive vehicles accounted for about 10% of all funds invested in mutual funds and ETFs. Its share now is closer to 50%. 

Intellectually people know that ETFs aren’t bank accounts, but haven’t had to grapple the reality of a bear market. I’m not making a specific prediction of a market crash or commenting on whether the current rise in equities is a bubble. What I am doing is highlighting the structural fragility in our system caused by the annihilation of risk free return from our saving and investing landscape. I’m not the first to make this point, but I think it should be front and center whenever we discuss compound interest. If a multi-year bear market feels impossible to you (stonks only go up), part of the reason is because it is unthinkable given our current structure. Such an event would be so profoundly dislocating for people (in a way previous bear markets were not), it is no secret policy makers in many countries are specifically doing what they can to prevent it. 

In summary, a massive structural change has occurred. It’s worked out okay so far so we don’t really discuss it, but it’s non-obvious that will be the case forever. Smarter people than me have more to say on this topic, Christopher Cole and Mike Green just to name a few.

What I’m getting at is in this minimum wage debate, there is already a minimum wage. Since we’re not debating creating one, but editing the current rate, I think we should be clearer that the “do nothing” side is also implicitly embracing the current rate. The “change” side has to justify where the new rate came from and what its effect will be. Why doesn’t the “do nothing” side have to defend the current rate as opposed to just attacking the proposed change?

The Congressional Budget Office produced estimates of job losses associated with raising the minimum wage. All three options were an increase in the minimum wage to $10, $12, and $15 compared to leaving it at $7.25. But why is $7.25 so great? Would the CBO produce estimates of job gains if we lowered the minimum wage? There are no Republicans clamoring not just to leave it at $7.25 but to lower it back to $5.15. Many Republicans actually believe we should abolish the minimum wage, but that’s been tangential to the discourse. All we’re debating is whether or not to raise it versus do nothing.

When detractors use memes of McDonald’s kiosks saying that minimum wage increases accelerate this, show them in response a picture of a backhoe. No one building a house today would think to just hire 10-12 people with shovels when you can rent a backhoe. The prevailing wages would say that it’s more effective to get the heavy equipment. Why couldn’t we lower wages and get these job killing backhoes out of use? It’s a silly argument and no one is making it, but when it comes to fast food we’re supposed to believe that it’s a given there should be human cashiers and kiosks are somehow bad. Wages aside, we know the backhoe is much faster and even at lower wages would still not be replaced by people again. Similarly, in restaurants kiosks tend to increase order size and order accuracy. They are here to stay whatever happens to the minimum wage.

All of this is to say we’re debating in a narrow lane of a specific change versus doing nothing as opposed to having a holistic debate about wages. We should identify that the opposition to a change gets an unfair advantage because they are never made to go on the offensive and actively defend the status quo, just tear down a potential change. This may sound like I’m supporting the increase to $15, but moreso I just want to hear someone explain why $7.25 is good as opposed to why $15 is bad.