The History of Compounding and Compound Interest

I'm Andy Temte and welcome to the Saturday Morning Muse! Start your weekend with musings that are designed to improve financial literacy around the world. Today is August 30, 2025.

Last week, we explored the many faces of return and discovered why different types of return calculations matter for making smart financial decisions. We touched on Compound Annual Growth Rate and mentioned that the power of compounding deserves its own deep dive. Today, we're beginning a three-part journey into what Albert Einstein allegedly called "the eighth wonder of the world"—compound interest.

While we've covered the moral evolution of interest and basic interest calculations in previous episodes, compound interest represents something far more powerful and mathematically elegant. To understand why this concept has captivated mathematicians, philosophers, and investors for centuries, we need to explore its historical development.

Benjamin Franklin's Grand Experiment

Our story begins with one of America's most ingenious founding fathers. In 1790, Benjamin Franklin died and left behind one of history's most famous demonstrations of compounding. Franklin bequeathed 1,000 pounds each to the cities of Boston and Philadelphia with strict instructions: the money was to be lent to young tradesmen for exactly 100 years.

Franklin calculated that after a century of compound growth, each fund would multiply substantially. But here's where Franklin's experiment became truly extraordinary—he stipulated that after 100 years, each city could spend part of the money on public works, but the remainder must continue growing for another 100 years. Franklin predicted that these funds would be worth millions after 200 years of compounding.

His mathematical framework proved sound, though real-world challenges affected the outcomes. When Boston's fund matured in 1990, it had grown to $4.5 million (approximately 2.7 million pounds at 1990 exchange rates). Philadelphia's fund reached $2.3 million (approximately 1.4 million pounds), significantly lower than expected due to early mismanagement and periods when the funds weren't actively lent out. Despite falling short of Franklin's optimistic projections, both funds still demonstrated the substantial power of compound growth over two centuries.

Franklin understood something that contemporary mathematicians were simultaneously formalizing: compounding doesn't just add growth—it multiplies it. He was essentially conducting a 200-year economic experiment to prove that patient capital, given sufficient time, could transform modest beginnings into substantial wealth.

This principle of compounding—where returns generate their own returns—would become the mathematical foundation for modern finance.

The Mathematical Foundations

While Franklin popularized compound interest in America, the mathematical foundations were being laid by European scholars throughout the 17th and 18th centuries. The period following the Bank of England's establishment in 1694 created sufficiently stable currency systems for mathematicians to develop sophisticated calculations about long-term growth.

Edmond Halley—yes, the same astronomer who identified Halley's Comet—made crucial contributions to compound interest calculations in the 1690s. Working for the English government, Halley used compound interest principles to create the first actuarial life tables—statistical charts that calculate life expectancy and mortality rates. These tables became the foundation for life insurance and annuity markets that still operate today.

Halley's work demonstrated that compound interest was a practical tool for managing risk and planning for the future. His calculations helped determine fair prices for life annuities, where people could pay a lump sum today in exchange for guaranteed income payments for life.

Swiss mathematician Leonhard Euler further refined compound interest calculations in the mid-1700s, developing formulas that made complex calculations more manageable. Euler's work laid the groundwork for modern financial mathematics, showing how interest can compound continuously rather than just annually, depending on the terms of the financial contract.

These mathematical advances occurred alongside growing sophistication in European financial markets. Government bonds, corporate securities, and insurance products all depended on accurate compounding calculations.

The Dutch Tulip Mania: Compound Growth Gone Wrong

To understand compounding's power, we must also examine its potential for destruction. The Dutch tulip mania of the 1630s provides a perfect cautionary tale about exponential growth in asset prices.

In the early 1600s, tulips were exotic flowers newly imported to the Netherlands from the Ottoman Empire. Their vibrant colors and unique patterns made them status symbols among wealthy Dutch merchants. As demand grew, tulip prices began rising—slowly at first, then dramatically.

What started as rational price increases based on genuine scarcity became a speculative frenzy driven by compound growth expectations. Tulip prices doubled, then doubled again, then doubled again. At the peak of the mania, a single tulip bulb could cost more than a skilled craftsman's annual salary.

The mathematical principle driving tulip prices was essentially compound growth applied to speculation. Buyers purchased tulips not for their beauty, but because they expected prices to continue compounding upward indefinitely. Sellers reinforced this expectation by demanding ever-higher prices, creating a self-reinforcing cycle.

When the bubble burst in early 1637, tulip prices collapsed by over 95% in a matter of weeks. Fortunes built on the expectation of compound growth vanished overnight. The tulip mania demonstrated that while compound interest can create wealth when applied to productive investments that actually earn returns, the same mathematical principle of exponential growth can destroy wealth when applied to speculation and asset bubbles.

Government Bonds and National Debt

The most significant application of compound interest during this historical period was in government finance. Following England's successful model with the Bank of England, European nations discovered they could fund wars and infrastructure projects by issuing bonds that paid interest over time.

The French government, struggling with massive debts from various wars—including the US Revolutionary War, issued increasingly sophisticated bonds throughout the 18th century. These instruments promised to pay holders not just their principal back, but compound interest over periods spanning decades. The French national debt grew exponentially as compound interest on previous borrowings added to new debt issuances. We’re living this phenomenon today with the explosion of the US National Debt and its corresponding interest burden.

This expansion of government debt had profound historical consequences. France's inability to service its compound-interest debt became a major factor leading to the French Revolution in 1789. The mathematical force that could create wealth for individuals could also bankrupt nations when applied irresponsibly to government spending.

The English government, by contrast, managed their debt more carefully and established the credibility that allowed them to borrow at lower interest rates. This "virtuous cycle" of responsible debt management and lower borrowing costs helped finance Britain's rise as a global power during the 18th and 19th centuries.

Why This History Matters

These historical examples reveal something profound about compounding: it's a force that has shaped nations, funded revolutions, and created (or destroyed) countless individual fortunes. The thread connecting all these stories is time. Compounding requires patience, discipline, and long-term thinking. Franklin's 200-year experiment succeeded because he understood that compounding's true power emerges not over months or years, but over decades and generations.

Next week, we'll move from these historical foundations to practical applications. We'll explore the basic mathematics that Franklin and Halley used, examine simple examples that illustrate compounding's power, and discover why understanding these principles is absolutely crucial for anyone in their twenties who wants to build substantial wealth over their career.

Until next week...

Grace. Dignity. Compassion.