A lesson from Vivaldi

In 1371, something interesting happened in Genoa. Francesco Vivaldi invented, or at least formalised, the concept of compound interest. It didn't come in quite the form that it does today. Vivaldi held large amounts of the debt issued by the municipality of Genoa.

In an attempt to help the city out of fiscal difficulties, he placed the debt in a sinking fund and demanded that the interest received every year be used to buy further debt until the fund owned the entire tranche of debt. It would then be cancelled. By 1454, the fund had bought 99.8% of the compera' in question (debt tranches were referred to as comperas this was the Compera Pacis), or around 12% of the public debt at the time.

The city showed its gratitude by erecting a statue of Vivaldi a few years later in the Palazzo San Giorgio. He looks pleased with himself, as well he might, given that he kicked off something of a trend (so many of Genoa's rich followed his example that statues had to be rationed), and that today paying or getting interest on interest is one of the cornerstones of our financial system.

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In Britain, we currently pay in the region of £43bn a year in interest on our £1trn-odd of outstanding debt. That debt is rising at about £10bn a month. So around 30% of the new debt we take on is purely to pay interest on the old debt. Then we pay interest on the new debt. Interest on interest. Imagine what your grandmother would say if you ran your personal finances like that.

Does it matter? That depends onwho you ask. George Magnus, our interviewee this week, says that the current absolute level of debt probably doesn't matter. As long as we can keep convincing the market that we're heading in the right direction with our deficit reduction, and as long as when we do bump up spending, we make a clear distinction between "gratuitous public expenditure" and infrastructure investment, for example, we should get away with it.

He might be right for a few years. But can the market really ignore the problems of countries whose basic fiscal strategy is to borrow money to pay interest on interest indefinitely?

Vivaldi's sinking fund gave bureaucrats an incentive not to raid the surplus it created: his rules stipulated that the second there was any evidence their snouts were in his trough, the money reverted to his family. Immediately.

Today, we don't have the equivalent of generous merchants how many of our CEOs and top bankers can you see chucking £10m into a compounding sinking fund for the national good? We also have no such breaks on spending. Our government, armed as it is with a central bank that has made it clear it will print at will, and a pretty feeble cuts strategy, is still little more than a money-spending machine. For us, compounding is just going to keep working in the wrong direction.