I recently came across a reference in a paper that gave me pause. It was hardly a focal point of the paper, really just a fleeting sentence, but it left me with a lot of questions. Essentially, in a paper discussing the European Union and eurozone issues, the author compared Alexander Hamilton’s “Sinking Fund” to the proposed European Redemption Fund.
It was the first I had heard of the sinking fund. What did it do? Was it successful?
I started off my research thinking that it would focus solely on Hamilton’s concept. But it took me in a totally different direction; the concept was so much broader than this single reference and started well before him. It’s turned into a three part series for this blog:
So, what is it?
The sinking fund uses a basic concept- compound interest*- to eradicate debt quickly.
The origins of the idea date back to 14th century Italy, but I’ll start with 18th century Great Britain and the United States. William Pitt (GB prime minister) employed the fund in the 1780s as British debt accrued at a rapid rate due to the war, and the US chose a similar path in the 1790s. A set amount of money was put aside every year to redeem outstanding government debt. The money was used to purchase public securities as an investment. Each year the interest gained on public securities was added to the fund. With the simple use of compound interest, the fund could grow significantly.
According to Swanson and Tout , the concept had become a ‘craze in public finance’ in the late 18th century, thanks to the writings of Mr. Richard Price. I know, I had never heard of him either.
*How the sinking fund works mathematically:
Remember this formula for compound interest? A= P(1 + r/n) ^nt. P is the principle, or starting amount, r is the annual rate of interest, n is the number of times the interest is compounded annually (often just once for sinking funds of yore), and t is the number of years the amount is deposited for.
Say you added 2% interest annually to a base amount of $100 for three years:
A= 100 (1 + .02/1)^3 = $106.12
Now, for the sinking fund, say you added 2% annually to a fixed amount ($100) that was contributed each year for three years:
Year 1 = 100 (1.02) = $102
Year 2 = 202 (1.02) = $206.04 <– 202 came from the year 1 total of $102 plus the new $100 contributed to the fund for year 2.
Year 3 = 306.04 (1.02) = $312.16
At the end of year 3, the fund now has $312.16. Imagine if the yearly contribution to the fund was one million pounds plus annual interest, like the Pitt plan. No wonder it became a ‘craze.’
1.Title: Alexander Hamilton’s Hidden Sinking Fund
Author(s): Donald F. Swanson and Andrew P. Trout
Source: The William and Mary Quarterly, Third Series, Vol. 49, No. 1 (Jan., 1992), pp. 108-116
Publisher(s): Omohundro Institute of Early American History and Culture
Stable URL: http://www.jstor.org/stable/2947337