Interest and Discount
What do interest rates have to do with global warming? Read on and see.
In the Middle Ages, paying interest on borrowed money was not approved by the Catholic Church, as also not with the Muslim and Jewish religions. Yet borrowers needing money would go to lenders, who had money to spare, and the borrowers compensated the lenders for the temporary use of their money. But what would they call this compensation? Since the Church did not allow the payment, there could be no word for it. Instead, it was called the money that "is between" (borrowing and repayment). Since Latin was the business language over all Europe, they would say, "inter est," meaning "is between," And thus a new word was coined.
Early money was gold and silver. Of course, it was heavy to carry these around, and if one merchant was carrying gold from Venice to London, and another from London to Venice, all they needed was to swap their gold. Goldsmiths in Venice would keep the Italian gold, and when the Venetian arrived in London, he would simply write an order for the Venetian goldsmith to pay the gold to whomever the London merchant wished. The orders to pay became known as "cheques" (American "checks").
Often the actual trading was done in Champagne (France), half way between Venice and London, where trade fairs were held. The hotel manager in Champagne would throw the traveling merchant's bag of gold on the shelf, where it would be given back intact when he left. Why? Well, if anyone cheated, the hotel keeper would have to pay up. If he did not, the traveler would hale the hotel keeper into the trade fair's "piepowder" court (piepowder = pieds poudrés = dusty feet = traveler), where the Count of Champagne enforced swift justice.
Of course, the goldsmiths had to be honest, as would also the traders, hotel keepers, or anyone else; or they would end up in piepowder court, and ultimately in gaol (British for "jail"). In this manner honesty was built into the capitalist system, which I believe to be the most honest economic system in the world, despite its recent scandals. (I believe most governments today are corrupt.)
If the Count did not enforce the law, the fairs would move someplace else. Yet it was of such obvious advantage to him to have the fairs in Champagne, that rival cities tried to mess up the roads going to Champagne. The Count would send his men to tidy up the roads. Naturally the Count could afford to send his men only so far, so eventually other cities had trade fairs too and every fair had its piepowder court.
The goldsmiths, being known by reputation for honesty, began to lend more money than the equivalent that they possessed in gold, since all depositors did not collect all their gold at once. The goldsmiths became known as "banks." They would keep a certain amount as "reserve." There was nothing dishonest about this banks still do it just so long as they keep enough reserves to cover any demands that might be made.
Each bank would issue its own notes, known as pounds, thalers, or dollars. Spanish pieces of eight also circulated in the United States as coins. They could be broken into eight bits, of which two represented a quarter. Just last year, as I explained the origin of "two bits" to my students, they all drew blanks. They had never heard the expression before. That's how language changes!
When borrowing from a bank, often the bank would deduct the interest at the beginning, in which case it became known as "discount." For example, if you asked to borrow $100 for a year at 10%, the bank would give you $90.91. The discount, $9.09, is the interest which the bank has kept (10% of 90.91 is 9.09, after rounding to the nearest penny). The amount you owe the bank in one year is $100.
From the bank's point of view, $90.91 is the present value of the $100 that they will receive from you after one year has elapsed. The value of a receipt of $100 one year in the future has been discounted in order to bring it into the present. This is called discounting a future value. The discount rate is, in reality, the cost of obtaining capital. Thus, "interest" and "discount" to economists are the same.
Although "discount" originally meant paying now instead of later, its meaning has been expanded to include any deduction from face value. If you buy goods at a face value (or price) of $100 but pay only $90, you have received a "discount." (Sometimes the "face value" or price has been increased to give everyone a discount. Watch out for that!) But for precision in language one should use the term "discount" only when referring to a future value.
For example: "I have contracted to sell my business for $500 million ten years from now, so at a discount rate of 6% its present value is $279 million." (The arithmetic: $279 = $500 / 1.0610)
Legal Tender and Discount Rates
When banks used to issue their own printed money, a $10 bill in cash issued by a bank in Portland, Oregon, might be deposited in New York for only $9. The difference was not a discount, but only compensation for the risk of accepting a bill from such a distance. Wanting to offer a national currency equally acceptable everywhere, President Lincoln proposed the National Banking Act (passed in 1865), which declared certain banks to be national banks, and their currency to be legal tender. "Legal tender" means that if you offer a bill from one of these banks in payment of a debt, and it is refused, then the debt is canceled.
Early in the twentieth century, bank reserves were held mostly in the form of gold, but supplies of gold became insufficient for financing the expanding world economy. To overcome this problem, central banking was established almost everywhere (the Bank of England, an exception, was founded in 1794 and became a central bank in the nineteenth century). In 1913, the Federal Reserve System was founded in the United States with twelve regional central banks.
Today's banks deposit their reserves in the Fed. If, at the end of the day, a bank is short of reserves, it borrows from a bank that has a surplus, or from the Fed. The rate of interest at which it borrows is the one set by the Fed, known as the Fed's discount rate. Decreasing the discount rate tends to spur the economy, by making capital cheaper. Increasing the Fed's discount rate tends to rein in the economy. Economists today argue whether the central bank should target economic growth or inflation when changing the discount rate.
Discounting the Future
What is the present value of benefits that may happen many years in the future? This is where discount rates become interesting and controversial.
As an extreme example, consider global warming. How do economists compare expenditures made today to alleviate global warming with their anticipated benefits that may not be visible for generations? Answer: they use the discount rate to convert the future benefit into a present value.
Let us simplify the problem and use purely hypothetical numbers, so as to reveal the fundamental logic without getting bogged down in details. Suppose that a particular national program for reducing greenhouse gas is expected to show a benefit to the nation of $10 trillion in about a century from now. What is the present value of this benefit, if the discount rate is 5%?
The arithmetic is simple: $10 trillion / 1.05100 = $76 billion.
In other words, if this hypothetical national program costs more than $76 billion, then it will not have been worth the expenditure. Such is the inexorable logic of discounting the future.
As an alternative to this kind of logic, environmentalists sometimes offer the wisdom of the Iroquois Confederacy, whose Great Law included this statement: "In our every deliberation we must consider the impact of our decisions on the next seven generations." The implication is that we should take into full account even events that may happen 175 years from now.
Yet even this Iroquois concept is not, in my opinion, incompatible with modern economics. I suspect that, if asked, the Iroquois elders would have agreed with the idea that the more distant in the future an event occurs, the less it should be weighted. In effect, the Great Law insisted upon a discount rate small enough so that events seven generations in the future would not be ignored.
The only essential difference between the modern and the Iroquois points of view is that modern economists equate the discount rate with the cost of capital, while the Iroquois used their constitution to ensure that their discount rate was very small, arguably as low as 1%. At a discount rate of 1% per year, the weight of an event happening 175 years in the future is still about 17%, whereas at a discount rate of 5% per year it is only about 0.01% (effectively zero).
From this we see that the discount rate really matters. It can make an enormous difference when evaluating costly programs whose benefits emerge only in the distant future. Like the Iroquois of pre-colonial New York State, contemporary environmentalists implicitly use a very low discount rate. In contrast, businessmen tend to equate their discount rate to the cost of capital, a much higher number, and therefore come to very different conclusions.
This has been a very short course in money and finance, but I believe it contains ideas that everyone should know.
Sincerely your friend,
(The final section on 'discounting the future' was contributed by Loren Cobb)
Please send comments on this or any TQE, at any time. Selected comments will be appended to the appropriate letter as they are received. Please indicate in the subject line the number of the Letter to which you refer!
Thanks for the refresher course on discounting and the formation of central banks. One thing to remember when doing "simple" calculations is that often the numbers we use to measure these events do not always "count" all the benefits nor all the costs of the problems/investments being considered. Spending money on clean air initiatives may not produce a positive net present value, but what is the present value of being able to breathe clean air? Cough, cough,
Free Polazzo, Anneewakee Creek Friends Worship Group, Douglas County, GA.
What about the inverse of the discounting problem? Things that happened in the past? If you have a valuable asset, such as the Chesapeake Bay oyster fishery, it would have a value with respect to both current and future harvests. If husbanded properly, the fishery would produce income for harvesters and sustenance for consumers in perpetuity. But, in the actual case, in the late 1800s they were pulling in 10 million bushels of oysters per harvest season. The fishery was not able to sustain this level of harvests and they have fallen over time so that in the most recent year on record harvesters took about 72,000 bushels of oysters. What is the present value (cost) of excess harvests in 1880 with respect to the current diminished productive capacity of the fishery? [calculations removed for brevity ed.]
In our little model, annual withdrawals in the decade ending with 2000 (270,000 bushels) would have been worth $5.4 million, meaning we are now losing $34.6 million per year in foregone harvests. The old oyster fishery is likely to never be restored...
What happens when we end up on the worser side of an inter-generational transfer? I think that the oyster fishery is just an easy metaphor for a whole class of market failures... We are dabbling around the edges, but our treatment of many of our natural resources is only occasionally rational.
I do not object to your use of financial metaphors in TQE 136 for environmental benefits... I think that's fine, ... but real world investors' needs for returns can turn all of this long-term economic theory on its head and you can get disasters like Northern California's redwood sell-off at some lower than actual valuation.
We need to remain mindful that assumptions about markets are not always met. We know that governments often don't get it right, but they can be useful for building public infrastructure. The infrastructure that is needed in this instance is the allocation and protection of property rights.
Economics can be used to make an argument for this and for showing how to more practically meet our environmental protection goals. I think that this may be an even more useful application than focusing on ways in which net present values (simply calculated) sometimes preclude more aggressive treatment of environmental problems.
Robert Wieland, attender, Third Haven Friends Meeting, Talbot County, MD.
Has anyone done any work on the possible costs of global warming? Many business are suddenly becoming concerned about it; are they seeing big enough discounted costs to be worth their worring about?
I can't imagine any business worrying about costs a hundred years in the future. They can't even be that sure they will be around then. Governments should, but their time horizon is the next election. Families are the only social entity that think much about that far in the future.
The businesses that do worry about the environment see cost and opportunities a lot nearer than 100 years off. Have they done an economic anlysis or seat-of-the-pants? What about non-economic costs like loss of species? And what about hedging? There was an article in Science a few months ago argung that with uncertainty hedging against future costs is worthwhile.
Bruce Hawkins, Northampton Friends Meeting (NEYM).
Publisher's reply: Power companies put an entry in their calendar 30 years into the future when they install a new power pole. I expect that timber companies schedule cutting 50 years into the future of a planting. It depends on the asset. If it's something with an extremely likely use, then the discount because of risk is fairly low, and a company can plan.
Families don't have a magic wand to eliminate the risk of asset value, however. Families have the advantage of existing 100 years in the future, but businesses operate in a climate where they still have a future value brought into the present. It's just a question of what is the discount rate. Russ Nelson.
Thanks for the interesting discussion of discount rates and banking. In Biblical times, I thought the borrowing of money was often a desperate act to forestall starvation, and that the debtor or his children would be placed in slavery if the debt was not repaid. This was why ancient religious authorities proscribed lending for interest. Is this correct or is there another origin for the proscribing of interest?
I would be interested in your comments about any historical material regarding the Jacksonian banking policies and the economic panic of 1837. It seems some of naïve Jacksonian thinking remains in some of the rants against the central bank of today.
Jim Booth, Lansing, MI.
As a "contemporary environmentalist," I would like to comment on the discount rates to be used for various purposes. There is the risk free discount rate we use for government bonds, and much higher discount rates we use for proposed environmental and other projects or investments with uncertain benefits or yields. We use a different discount rate in evaluating the current value of the welfare of future generations (or utility of future individuals if we set per capita goals.) Some economists say the discount rate for the welfare of future generations must be zero, for we have a duty to pass on the world to future generations in a better state than when we received it.
I submit that if you believe in "sustainable development" (or sustainable consumption) for future generations, you are discounting future welfare (consumption) with a zero discount rate. Robert Solow of MIT defines sustainable development as investing enough now to offset the curent and future losses from use of exhaustible resources (petroleum) and environmental pollution (global warming), so that while the composition of consumption in future generations changes, overall welfare remains constant or rises.
I submit we should proceed in the following manner:
I suppose you will disagree with my position, but I think readers of TQE might enjoy our discussion.
William G. Rhoads, Germantown (PA) Meeting.
Your article talks of a subject I find highly interesting. However, when discussing the economics of environmental concerns I have some concerns with our measurement system. When we base justifications upon ecological impacts and translate those ambiguities into even more ambiguous economic impacts, what progress is really made? I think many are naturally attracted to that level of scientific approach in this day and age, but I personally accept we are very far from achieving any precision of analysis when it comes to our macro environment... What cannot be accurately measured cannot be accurately reacted to under any economic system.
Mark Powers, a Friend in Minneapolis.
This comment responds to a number ot TQE letters that speak to growth and development, globalism, improving human well-being, and protecting the environment.
It is hard for me to understand discussions of improving economic well-being without reference to population growth. My impression is that economic success means taking the resources available on the planet earth and using them as efficiently as possible without impairing the natural environment that makes future economic growth possible.
The larger the world population the greater the damage to the environment. Shouldn’t the No. 1 economic priorities be reduction of world population, protection of the environment, and finding a realistic balance between population and the availability of resources to sustain such a population?
How can migration of people from China, India, Central America, or anywhere else as cheap labor be any more than a short-term benefit as long as world population continues to soar and diminution of world resources escalates?
I would think that reducing world population would be the No. 1 factor in any economic recommendation for the future, ahead of increasing productivity which often increases environmental destruction as it usually calls for increased use of energy resources.
Henry Halsted, Racine, Wisconsin
Reply: Excellent points, well worth further discussion. I can see that we will have to dedicate another TQE to this topic. Loren.
I am delighted to have just come across your journal and hope to re-visit from time to time. I might even subscribe! Your introduction to discounting is useful but as some of your readers point out, it is not clear any more that the conventional approach to cost benefit analysis, using discounting, is consistent with the notion of environmental sustainability.
Orthodox economic theory tends to emphasize the present discounted value of future net benefits, which gives the present privileged status. I’m sure the results of today’s studies, relied upon by today’s decision makers, will yield different results on long term issues when my children are my age. This raises the question of how and when to adjust discount rates, or perhaps it suggests that some things may have an absolute value. Another question is whether one culture values the same set of criteria as another culture that may also challenge the orthodox theory. A new field of 'sustainability economics' is emerging which makes interesting reading.
David W. Brett, attender, Devonshire Street Meeting, Sydney, Australia. [15 Dec 2005]
Reply: Welcome! Your comments lead into interesting areas of thought. The idea that there might be values which are timeless and absolute, and cross-cultural as well, is an underlying assumption of all of the major religions of the world. Indeed, one could say that economics first began when problems with this 'universal value' concept began to appear. Loren
The Pro-Growth Progressive: An Economic Strategy for Shared Prosperity, by Gene Sperling. Published by Simon & Schuster, 2005.
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Publisher: Russ Nelson, St. Lawrence Valley (NY) Friends Meeting.
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Copyright © 2005 by John P. Powelson and Loren Cobb. All rights reserved. Permission is hereby granted for non-commercial reproduction.