February 10, 2008

Wiki Weekend: Time Value of Money

Karen at verbatim blog has a feature called “Wiki Wednesday” in which she uses Wikipedia’s random function to plumb the brain of the wiki for some new fact, and she shares that with her readers.

I liked the idea, but I seem to be searching Wikipedia all the time for my own purposes, so I thought I’d create my own riff on her idea, which I will post on the weekend, or on Wednesday, depending.

Wiki Weekend will feature some concept I searched for on Wikipedia either because I’d never heard of it before, because I needed details on the concept, or because I saw an opportunity to deepen my knowledge of the subject1. I’ll present the concept and then tell you why I was looking for it. We’ll continue so long as I do not suddenly decide that it is a lame idea.

This edition’s concept is:

Time Value of Money

The time value of money is based on the premise that an investor prefers to receive a payment of a fixed amount of money today, rather than an equal amount in the future, all else being equal. All of the standard calculations are based on the most basic formula, the present value of a future sum, “discounted” to a present value. For example, a sum of FV to be received in one year is discounted (at the appropriate rate of r) to give a sum of PV at present.

In other words, money now is often better than money later.

Read the Wiki entry for the details, but here’s my oversimplification: Over time, there is a potential for money to turn into more money. There is even an expectation that money should do this, so long as you hold the money in some interest-bearing account. So, according to the Wiki entry, the change in value over time can be calculated with various formulas.

The idea of a time value of money is something (like so many things) my dad taught me about when I was just a wee lad. And when I looked it up, I was thinking of the more general idea that money now is better to have than later.

What made me look it up is all the discussion over the stimulus package that Congress passed. People will be getting chunks of money which they are expected to spend. The intended result is to stimulate the economy by convincing consumers not to stop spending just yet. Consumer spending needs to continue in a healthy economy2.

Some people were leery of the one-time rebate because they thought the government was going to demand it back (like a loan) in a future tax year. there was some confusion over how this rebate was being reported. As I understand it, you won’t actually be asked to pay it back. It’s more like a rebate that you would get in the future, but since they need the economy stimulated now rather than later, they’ll send out the checks now even though it’s a rebate on taxes you haven’t paid yet.

This law lowered your taxes, so you wouldn’t have been getting that money in the future. You’re only going to have to “pay it back” in the sense that the government is not going to give you this same rebate twice. I agree, it’s a little confusing. But understand that it is not a loan, and you won’t be asked to pay it back.

Why Want It Now?

Let’s assume that you did have to pay it back later, like a loan. Some people turned their nose up at the money because they didn’t want to have to pay it back. But according to the time value of money, you should never turn down dollars, even if you have to pay them back in the future. This is part of why institutions charge interest when they loan you money. With money comes potential, and they are charging you for their loss of potential, because you hold the money rather than them.

  • If the government “loaned” you $1,000, you could invest the money, and then pay them back. You’d get to keep any capital gains or interest.
  • You could turn around and lend the money to someone who needed it, and charge them interest like a bank. Again, you’d get to keep the interest.
  • You could use it to pay for something related to your means of income. lets say you bought some musical equipment that allowed you to play gigs you couldn’t before. You’d get to keep the money you earned.* You could use it to buy a laptop earlier than you had planned. Whatever you plan to use the computer for, you now have an additional year of your life using a laptop. Even if this didn’t result in you earning more, you would experience the benefit earlier in your life. That has some value.

When the value of the dollar is dropping, dollars today really are, themselves, worth more than dollars in the future. If prices are rising, you’ll get more for your dollar today. I am not an economist, so your mileage may vary.

So, the concept of a time value of money means that money in the hand is better than money promised in the future. So, however you can, try to lay hands on that money as soon as possible and use it wisely!


1 Yes, I know that Wikipedia is not always the best place to broaden your knowledge of a subject. I didn’t say Wikipedia was my only source, but it is one of the sources which best lends itself to this blog feature. But thank you for your concern!

2 No, this post doesn’t mean I think the stimulus package is the solution to the recession.

Posted by James at February 10, 2008 9:24 AM
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Comments

Lets face it, this bill is not about stimilating the economy. It's about bribing voters. No one wants their opponent to be able to say, "I wanted to give you $600, but Senator Jerkhead over there wouldn't let me."

We didn't get through the great depression by offering tax cuts. Hell, even the recession of the early 90s wasn't "solved" that way. It's truly sad that the conservatives have so dominated discourse for so long that even most Democrats are simply proposing "tax rebates" as a way to "stimulate the economy."

With much of the weakness being related to housing, it's not like that $600 is going to fix that problem. I'm not going to go out and buy a new house or remodel my kitchen because the government gave me a $600 bribe. At most I might buy $600 worth of stuff at Best Buy, and that might help create a few more jobs in China - and one minumum wage job here.

We have bridges that are failing, a water infrastructure that is collapsing, and a need for a massive investment in building sustainable energy sources. Fixing all of those things will both create jobs AND give us all benefits we need, as well as setting up long term economic growth because businesses will have the roads, water, and energy they need without having to pay exorbinant prices for them.

These would be far better places to invest the hundreds of billions of dollars than just giving every voter a tiny bribe. But after decades of Reagan/Bush/Clintonomics, I really don't expect much more than platitudes about how the market will solve everything if we just cut taxes.

Posted by: David Grenier at February 10, 2008 11:16 AM

True, that.

As Robert Reich said on his blog, "middle-class families have exhausted the coping mechanisms they have used for more than three decades to get by on median wages that are barely higher than they were in 1970, adjusted for inflation."

First: they got women into the workforce. Next: they kept us working longer (less time off). Thirdly: we borrowed, borrowed, borrowed.

The wages of the lower two thirds of this country have to increase, somehow. And foreign investment would help stem the decline of the dollar, which makes us all more poor. And a better education would prepare people from the lower socioeconomic sectors for high-tech jobs. And, of course, unions to hold the line against the erosion of worker's righter, wages, vacation time, etc.

Tax cuts are typical short-sighted distractions, a bone thrown to the electorate while the upper socioeconomic classes work their magic to widen the income gap.

I hope that if Obama wins, he asks (former Clinton Secretary of Labor) Reich, or folks like him, to work in his administration.

Posted by: James at February 10, 2008 1:25 PM

Er, that's "workers rights" not "worker's righter."

And, research into sustainable energy sources seems to me to be a well-timed obvious win for the country. If only we didn't have Iraq as an albatross. You know, that country where everyone has health care, paid for by the US government. That health care that we're told would be the worst thing possible if our citizens were to have it.

Fixing bridges and infrastructure is not a bad idea, either, but it is marginally better than the tax rebate stimulus. It'll put off the recession, but I doubt it would reverse it. Research into alternative energy, however, would have a sustained impact.

Look at me, all amateur economist!

Posted by: James at February 10, 2008 1:30 PM

James,

But the thing is, the bridges and roads NEED to be fixed. As does the water infrastructure of the country. Forget about economic stimulus for a second, and just think not-collapsing-bridges-stimulus. But this stuff keeps getting defered and defered due to lack of funds. So now we have an epidemic of sinkholes caused by aging water infrastructure, we have bridges collapsing and levees being breached. It's all this unsexy stuff that we take for granted that's been neglected for pretty much my whole adult lifetime, and likely yours as well.

Posted by: David Grenier at February 10, 2008 5:44 PM

So let me add my two cents.

Three weeks or so ago, a report on NPR featured an interview with someone who said the government is hoping we won't spend this "rebate check" on current debt--which most Americans have, up to their eyebrows--but that we'll go out and spend spend spend to stimulate the economy.

HAH! What a laugh.

I pay my taxes so important things will get taken care of, like, oh, paving streets, plowin them, taking care of those less fortunate than I by funding Head Start and Meals on Wheels, etc. etc., que sera sera.

It burns my ass to hear Washington idiots, and the Chief Idiot, Bushy Bush, sound like they're performing some great humanitarian act by giving us some truly inconsequential amount of money. I say inconsequential because, like Dave said, $600 per household is unlikely to quell things like the meteoric crash of the housing market, but, just think what all that money, in one lump sum (as it is where it sits in the Treasury now), could do to, should do, which is why we all pay taxes.

Whew. The topic of Bush's feel-good "check's in the mail" scheme i s is exhausingly irritating (or perhaps irritatingly exhausting) to discuss. However, it does give me the perfect entre to sharing a great article from today's New York Times, the title of which is "A Fairer System: Tax the Annoying":

http://www.nytimes.com/2008/02/10/business/yourtaxes/10essay.html?_r=1&scp=1&sq=tax+the+annoying&st=nyt&oref=slogin

Posted by: Patti M. at February 10, 2008 6:43 PM

I'm not against fixing the roads, I was just speaking in terms of what will offer a more lasting economic impact.

If McCain gets in, I don't expect we'll see the roads fixed or a meaningful investment in alternative fuels.

Posted by: James at February 10, 2008 8:10 PM

Well, the alternative fuels discussion is one to watch very very carefully and with a very scepitcal eye. Be sure to ask for the supporting data when someone who is pro-ethanol begins to talk up the benefits.

I encourage those interested in finding out more to read this article from the 8 February 2008 edition of Science. Sadly, all that's available to non-subscribers is the abstract, which I will give here:

"Most prior studies have found that substituting biofuels for gasoline will reduce greenhouse gases because biofuels sequester carbon through the growth of the feedstock. These analyses have failed to count the carbon emissions that occur as farmers worldwide respond to higher prices and convert forest and grassland to new cropland to replace the grain (or cropland) diverted to biofuels. Using a worldwide agricultural model to estimate emissions from land use change, we found that corn-based ethanol, instead of producing a 20% savings, nearly doubles greenhouse emissions over 30 years and increases greenhouse gases for 167 years. Biofuels from switchgrass, if grown on U.S. corn lands, increase emissions by 50%. This result raises concerns about large biofuel mandates and highlights the value of using waste products."

See a recap of the info in these two articles:

Biofuels emissions may be 'worse than petrol'
19:00 07 February 2008
NewScientist.com news service
Jim Giles

http://environment.newscientist.com/article/dn13289-biofuels-emissions-may-be-worse-than-petrol.html

Biofuels May Hinder
Antiglobal-Warming Efforts

Carbon Emissions
Could Increase
As Land-Use Shifts
By GAUTAM NAIK
February 8, 2008; Page A4

http://online.wsj.com/article/SB120241324358751455.html?mod=googlenews_wsj

Posted by: Patti M. at February 11, 2008 9:46 AM

I apologize for not supplying the citation information for the abstract. Here it is:

Published Online February 7, 2008

Use of U.S. Croplands for Biofuels Increases Greenhouse Gases Through Emissions from Land Use Change

http://www.sciencemag.org/cgi/content/abstract/1151861v1?maxtoshow=&HITS=10&hits=10&RESULTFORMAT=&fulltext=ethanol&searchid=1&FIRSTINDEX=0&sortspec=date&resourcetype=HWCIT

Posted by: Patti M. at February 11, 2008 9:48 AM

That was also in the NYT:
http://www.nytimes.com/2008/02/08/science/earth/08wbiofuels.html?_r=1&oref=slogin

I heard the "conservative" radio host on WSAR saying that the rebate was going to make a big difference to his family. That is hard for me to imagine. How does such a small one-time payment make a difference? Why are you living outside your means? If you have no choice, i.e. the bare bones necessities are outside of your means, then how is $600, for example, going to help? And if you have a choice, then stop living outside your means. This is the "please continue to live outside of your means" rebate, and it's depressing.

Posted by: Maggie at February 11, 2008 10:24 AM

What? What's this? Are you questioning my god-given right as an American to live beyond my means?

I think the terrorists have just won!

Posted by: Patti M. at February 11, 2008 10:34 AM

Well one thing people in MA can do is quit bitching about not being able to afford the new mandated health care. If I read one more letter bitching about not being able to afford the 100 and something dollars a month when I'm sure that person spends at least that much for cable, cellphones, internet connections, wide screen TVs, daily $4 coffees, etc. I'm going to scream. No they'd much rather not have health care and gamble on the fact that if they're lucky they won't get sick and if they are unlucky then the state will pick up the tab.

Posted by: B.O.B. (bob) at February 11, 2008 10:40 AM

Oh and they can also spend it on a new tv or converter that the government is mandating they buy if the don't happen to have cable/satelite.

Posted by: B.O.B. (bob) at February 11, 2008 10:43 AM

But I was going to spend my $600 on a humongous TV! After all, the prez and his buds say the point of these checks is to "stimulate the economy," so I'm gonna be a good citizen and spend spend spend!

Forget spending on the healthcare, though--boring!

Posted by: Patti M. at February 11, 2008 10:44 AM

They might have to buy that TV after all--see this article in today's Globe, which reads, in part: "Nearly 6 million people with digital receivers may still lose TV signals when digital-only broadcasts begin next February, says a study by Centris, a market research firm in Los Angeles."

http://www.boston.com/business/technology/articles/2008/02/11/6_million_may_lose_digital_tv_reception/

Whoops!

Posted by: Patti M. at February 11, 2008 10:46 AM

Maybe it was meant to SIMULATE the economy.

Posted by: briwei at February 11, 2008 12:59 PM
I heard the "conservative" radio host on WSAR saying that the rebate was going to make a big difference to his family.

Typical disingenuous junk. Specifically: the point of the rebate is not to make an immediate difference in your family, but rather to improve the economy, a separate question entirely.

These people always seem to see taxes, no matter what, in these simplistic terms.

Clearly, this "conservative" is only happy when the government is writing him checks. When the government writes a welfare check that helps someone else's family, he screams like he can't find his pacifier.

Posted by: James at February 11, 2008 1:05 PM

Bada BING!

Posted by: Patti M. at February 11, 2008 2:20 PM

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