Time Value of Money, Interest, Risk, Opportunity Costs and Banking

Posted by PITHOCRATES - January 2nd, 2012

Economics 101

Entrepreneurs have to Borrow Money because their Income comes AFTER they Build Things

A lot of things came together to give us a modern civilization.  Food surpluses, division of labor, money, religion, rule of law, free trade, free labor, prices, incentive and competition.  As well as other important developments.  Such as banking.  That addressed the time value of money.  And the risk of lending.

Before farmers can sell their harvests they have to plant them first.  This takes money.  Which raises an obvious question.  How do farmers get money to plant a crop?  When their income comes AFTER the planting of that crop?  Entrepreneurs have the same problem.  They can build things to sell.  But like the farmer they have to buy materials first.  Which takes money.  So how do entrepreneurs get money to build the things they build?  When their income comes AFTER the building of these things?

Of course farmers and entrepreneurs have to borrow money.  Say from a parent.  Who has been saving up for a really nice vacation.  A parent can loan the farmer or the entrepreneur money.  But that means that they may have to postpone their plans.  Or change their plans. For the same vacation may cost more next year than it does this year.  If they loan their money and get the same amount back they won’t be able to afford that same vacation.  Unless they charge interest.  So that when they get their money back AND the interest they can then afford that same but now more expensive vacation.

A Bank collects Deposits from Numerous Depositors so they can lend it to the People who Need Capital

This is the time value of money.  Over time money buys less.  Because it’s worth less.  The same amount of money will buy more today than it will 10 years from now.  This lost value is the cost of borrowed money.  And why borrowing money typically incurs interest.  Money a borrower owes in addition to the amount borrowed.  The interest compensates the lender for the lost value of their money.  So when you repay it they don’t lose any purchasing power.  And the lender can buy the same things that they could have when they loaned you the money.  Like a postponed vacation that became more expensive over time.

As the economy became more complex it required more borrowed money to pay for the production of other things.  Things that we sell much later than when we purchased the material to make these things.  Expensive things.  Tools.  Equipment.  Factories.  Trucks.  Costs so great that a person’s parents may not have enough savings to finance these things.  But they could if we combine their savings with other people’s savings.

Alexander Hamilton said a person’s savings was just money.  But when added to the savings of other people that money became capital.  Large pools of money available to loan.  So entrepreneurs could borrow money to buy tools, equipment, factories and trucks.  This important part of business became a business in itself.  The banking business.  A bank collects deposits from numerous depositors.  So they can lend it to the people who need capital.  They pay interest to depositors to encourage them to deposit their money.  And charge interest to borrowers to pay the depositors’ interest and other costs of running the bank.

Charging Interest Compensated the Lender for the Risk they were Taking and is a Necessary Part of Capitalism

Banks get a lot of bad press these days.  Since the dawn of banking, really.  People say bankers get rich for doing nothing.  Using other people’s money to boot.  Some call it a sin.  Usury.  Making money simply by lending money.  The ancient Jews forbade it.  So did the Christians.  Even the Muslims.  (And still do.)  But without banks we wouldn’t have a modern civilization.  In fact, if we had no banks you would not recognize the world you’d be living in.  There would be no middle class.  And our economic system would probably still be based on Manorialism.  Where most of us would still be serfs.  Working the land for the Lord of the Manor like our distant ancestors did in the Middle Ages.

There would have been no Industrial Revolution.  No cell phones.  No Internet.  Because all of these things required capital.  The pooling of people’s savings.  To provide the investment capital it takes to finance these things we take for granted in our lives today.

But things changed.  First the Jews started lending money for interest.  Then the Christians followed.  Seeing that business and commerce needed to borrow money.  And that lending money incurred risk.  (Some people might not repay their loans.)  And there were opportunity costs.  (The other things they could do with that money.)  Charging interest compensated the lender for the risk they were taking.  It wasn’t usury.  It was a necessary part of capitalism.  And the modern world we take for granted today.

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