Compound Interest Is The Least Powerful Force In The Universe

I.

I’m still iffy on Vox. Some of its reporting is excellent – their article on Governor Cuomo and the shift away from progressivism in the Democratic Party was especially enlightening. Other parts, especially the editorials, are atrocious and utterly without subtlety.

Ezra Klein’s article on compound interest was the latter.

The reaction to Ta-Nehisi Coates’ magisterial essay on the lingering effects of American racism is polarized around people’s reaction to the word “reparations.” But much of the story he tells is about something simpler, and completely uncontroversial: the power of compound interest.

You might remember, as a kid, getting this problem on a test: Would you rather have $10,000 per day for 30 days or a penny that doubled in value every day for 30 days?

The answer, of course, is you want the penny that doubles in value every day. If you take the $10,000 you end up with $300,000 after the first month. Take the penny and you end with about $5 million.

What Coates shows is that white America has, for hundreds of years, used deadly force, racist laws, biased courts and housing segregation to wrest the power of compound interest for itself. The word he keeps coming back to is “plunder.” White America built its wealth by stealing the work of African-Americans and then, when that became illegal, it added to its wealth by plundering from the work and young assets of African-Americans. And then, crucially, it let compound interest work its magic.

Today, white America is one of the richest and most powerful populations the world has ever known. And it wonders why African Americans just can’t seem to keep up. “In America,” Coates writes, “there is a strange and powerful belief that if you stab a black person 10 times, the bleeding stops and the healing begins the moment the assailant drops the knife.”

[…]

“The popular mocking of reparations as a harebrained scheme authored by wild-eyed lefties and intellectually unserious black nationalists is fear masquerading as laughter,” Coates writes. It’s also the intellectually unserious response of people who believe that because they never owned slaves or drank from a whites-only water fountain they weren’t the beneficiaries of American racism. They may not be the villains of American racism, but they are the beneficiaries of it. The average white southerner in 1832 was far poorer than the average white southerner today, and part of that vast increase in wealth and income and knowledge and social networks is the result of compound interest working its magic on what the slaveowners and the segregationists stole.

It’s as simple and clear as a child’s math problem. The people who benefitted most from American racism weren’t the white men who stole the penny. It’s the people who held onto the penny while it doubled and doubled and doubled and doubled.

There are many many complicated moral arguments for and against reparations. Like Klein, I don’t want to get into any of them except the financial aspect of how much modern whites benefit from the lingering effects of slavery, and how much modern blacks are harmed by them.

I want to make one very loose argument and then one based off of empirical research.

The loose argument is that the best way to determine whether modern whites have gained from owning slaves (and I know Klein’s argument takes into account other forms of oppression beyond slavery, but slaves will be a good first approximation) is to see if formerly slave-owning societies are richer than formerly non-slave-owning societies.

The state with the highest percent slaves before the Civil War was South Carolina, with Mississippi number two. Mississippi is the poorest, and South Carolina the fifth poorest of the fifty states today. Except for Virginia, every single state in the former Confederacy is poorer than the US average.

This is somewhat confounded by the high level of poor blacks in these states, but remains true even when you look only at the income of white residents. For example, if Mississippi whites were their own state, they would be 39th out of 50 in terms of per capita income. South Carolingians would do better but still be below the national average. If all states suddenly became all white, Mississippi and South Carolina would drop right back down to the bottom.

So the whites who had the most opportunity to benefit from a supposed ability to earn compound interest on slavery earnings clearly didn’t do that.

While one could make the argument that the gains from slavery left Mississippi and the Deep South to enrich all whites, this seems a bit forced. The US was much less interconnected in those days. And other places that had no connection to slavery still outperform the Deep South: Italian whites, for example, still do comfortably better than whites from most Southern states.

One could always argue that Southerners would be even poorer today if not from all the compound interest they received on their slavery earnings. But Southern poverty is already a bit of a puzzle. To make them too much poorer would require them to descend into levels of squalor totally unknown in any First World country.

I think we should at least look at an alternate hypothesis: people are really really really bad at passing ill-gotten wealth through more than a generation or two.

II.

The descendants of rich people tend to stay rich even three hundred years later. For example, Gregory Clark looked at social mobility in Sweden. A famously mobile society, Sweden is also a good place to study social mobility since nobles and commoners had different last names back when the feudal system was in place around 1700. Non-nobles are forbidden to change to noble-sounding surnames even today, so names should be a fossil record of who’s descended from the really rich people.

Clark found that among highly-educated well-paying professions like doctors and lawyers, people with aristocratic surnames are represented around four to six times the level expected by chance. He uses this to describe a statistic “b” signifying the rate of regression to the mean with each generation.

Suppose nobles are eight times more likely to be doctors at the end of the feudal period. If b is low, say 0.35, then they will quickly regress to the population’s average – according to Clark’s graph, it will take about 80 – 90 years (= 3 – 4 generations?) before this happens. If b is high, say 0.75, it will take practically forever – he demonstrates that even after 200 years, there will be noticeable differences.

Clark finds b to be between 0.6 and 0.8 in Sweden, and then goes on to show it is similar pretty much everywhere and across all time periods. The Economist describes his research by saying:

With surprising consistency across countries and eras, mobility is found to be painfully slow. Birth has predicted more than 50% of one’s income or education status, Mr Clark reckons. Erasing the legacy of past prosperity takes 10-15 generations rather than the three or four implied by sunnier estimates. So the shadow of 18th-century wealth still darkens income distributions today.

This sounds very promising for Ezra Klein’s compound interest argument and really bad for my “Southerners are really bad at holding on to wealth” argument. But Clark takes it in a totally different direction. The Economist again:

The most unexpected finding [is that] efforts to democratise education and eliminate discrimination over the past century appear to have had no discernible effect on mobility, leading Mr Clark to conclude that mobility is strongly linked to underlying social competence—an “inescapable inherited” trait. Only the intermarriage of people who are more prosperous and educated with those less fortunate will dilute the genetic resources of well-off families, slowly pushing them back towards the average and preventing the rise of a permanent overclass.

I just want to briefly pause our economics discussion to point out that Professor Clark has written two books on his theories, and they they are called A Farewell to Alms
and The Son Also Rises. Please take a moment to be delighted by that.

III.

Okay, so wealth lasts a really long time, and Klein thinks that’s because of compound interest and Clark thinks it’s because of “inescapably inherited social competence” which sounds a lot like a euphemism for genes. To differentiate between these two hypotheses we would need to randomly select a bunch of people, give them a lot of wealth, and follow them for a couple of generations to see whether their descendants compounded that advantage or regressed back to their genetically programmed level.

I am familiar with only one well-studied example of this happening.

In 1830 the government stole the land of the Cherokee Indians. Lots of white people wanted to settle the newly available territory, so the state of Georgia proposed a lottery, where the winners would get large fertile farms on the conquered area. Not only were the farms available in the lottery much bigger than those owned by the average Georgia farmer at the time, but lottery winners were totally allowed to sell the farm they had just won to someone else and pocket the cash. Nearly every single white person in Georgia at the time entered the lottery, because hey, free money.

Bleakley and Ferrie track the winners and losers of the land lottery for several generations. They find that the first-generation winners did very well. The average farm won in the lottery was worth $900 in 1830 dollars, which was the equivalent of three years’ unskilled labor (so think about $60000 today). It was also a gift that kept on giving, since most people would farm the land and be able to grow lucrative crops every year indefinitely. According to the study “two decades after the lottery, winners are on average $700 richer than a comparable population that did not win the lottery”. Remember, this is back when $700 was real money.

In a second study, they look at the effect a couple of generations down the line. They find:

Sons of winners have no better adult outcomes (wealth, income, literacy) than the sons of non-winners, and winners’ grandchildren do not have higher literacy or school attendance than non-winners’ grandchildren. This suggests only a limited role for family financial resources in the formation of human capital in the next generations in this environment and a potentially more important role for other factors that persist through family lines […]

[This] should have relaxed the budget constraint faced by poorer households and allowed them to invest more in the human capital of their children. If human capital was unaffected in the next generations, this is evidence in favor of the view recently advanced by Clark and Cummins that a substantial portion of the intergenerational correlation in outcomes is driven by fundamental, family-specific effects (the family’s cultural and genetic infrastructure)

Studies of modern-day lottery winners show much the same, albeit on a much-reduced time scale. And closer to the original issue, studies attempting to compare enslaved blacks versus free blacks appear to show it didn’t actually take that many generations for outcomes to equalize.

IV.

I am disappointed that all we have to go off of are these kinds of hints and whispers.

This seems like maybe the most important question in economics. Certainly in sociology. It seems terribly important to public policy, not just in terms of reparations but in how much we spend helping poor families and more important how we help poor families. If Clark’s view is right, the best we can do is alleviate their suffering by making sure that being poor isn’t an especially unpleasant state and everyone has good access to social services. If Klein is right, we should be making huge cash transfers to get people out of poverty traps so that their descendents will reap the compound interest and become rich.

(there’s also the slight confounding factor of the South being demolished during the Civil War, which could disprove Klein’s particular example while not necessarily supporting Clark or the general case)

I want to repeat Clark’s quote to the Economist for emphasis:

The most unexpected finding [is that] efforts to democratise education and eliminate discrimination over the past century appear to have had no discernible effect on mobility.

If Clark is right, almost everything we’re doing is a waste of time.

There are some good arguments about why poverty might make people less successful over long time periods, like cognitive load effects. But there are also some good counterarguments – if that’s true, how come the second-generation descendents of Vietnamese boat people, who came to America with nothing, now have notably higher household incomes than white Mississippians, with all their years of benefitting off other people’s slave labor?

Overall, these are the sort of really complicated problems I would have expected a supposedly more sophisticated media outlet like Vox to cover or help raise awareness on.

Instead it uses mere assertion to tell use that denial of compound interest is an “intellectually unserious response” and that Klein’s case is “as simple and clear as a child’s math problem.”

Sorry, Vox. I’ll keep reading you for your occasional article about the case for raising chickens in virtual reality. But intelligent and sophisticated you are not.

EDIT: Tyler Cowen gives a different perspective on the same Klein article over at Marginal Revolution

EDIT 2: The quote I stole the title from is probably not legit

EDIT 3: One could try to reconcile Klein and Clark by saying that sure, wealth doesn’t persist in families across generations but it does in societies (presumably it gets transferred from family to family within the society but continues to exist). But then there would be no reason to favor white people and their descendants as especial beneficiaries.