Is the Time Value of Money a Fundamental Law?
Today we hear about what seems
to a western ear to be the strange Islamic practice of prohibiting interest
(riba). This religious prohibition has given birth to the modern industry of
Islamic banking. To the west it is hard to understand the efforts made by Islamic
banks to structure transaction that may technically avoid “interest” while
still compensating the bank by having the borrower pay a larger amount of money
in the future than the bank handed over today.
What escapes most people in the
west is the fact that Christians in Europe followed the same practice only a
few hundred years ago. Christians believed that it was a terrible sin to charge
interest on a loan. The Christian solution to the problem was to recruit Jews
to become the bankers. In the twisted medieval mind this solution solved the
problem. The Christian had to worry that he risked excommunication and the
fires of hell if he charged another Christian interest. However, the Jews were
already going to hell, so they in the medieval mind[i]
they risked nothing by becoming bankers and charging Christians interest.
Neither modern Islamic bankers,
nor medieval Christians were willing to simply hand out $1,000 today in
exchange for $1,000 five years from now. Instead they went to great lengths to
circumvent their own religious beliefs prohibiting the charging of interest.
This caused me to wonder if interest, i.e., the time value of money is really a
fundamental law of the universe. It seems to be so compelling that even those
who are worried about burning in eternal fire are still compelled to comply
with its dictates, even if they come of with technical arguments to convince
themselves that they are not bowing to the principle of the time value of
money.
I think that the answer does
lie in the fundamental structure of the universe. The arrow of time points in
one direction. The past is knowable, but the future is always uncertain. This
uncertainty means that we live in a risky place. It is this risk that makes the
time value of money a fundamental law. This risk can be divided into three categories,
all of which compel us to believe that $1 dollar today is worth more than $1
tomorrow.
The Three Risks
1. The Risk Associated with the Lender. We prefer to have something now rather than later. In part
this reflects our mortality. The greater the period of time the less certain it
is that we will be in a condition that will allow us to enjoy our money. In
fact, the longer the period that passes, the greater the chance that we will be
dead and the money will be beyond our reach.
2. The Risk Associated with the Borrower. We understand that things happen and that a longer period of
time makes it less and less certain that we will be repaid. Borrowers can
lose jobs, become sick, go out of business, skip town or like lenders, die. As
every loan collector knows, the longer the delinquency the less likely the
repayment.
3. The Risk Associated with the Money Itself. We normally expect that there will be inflation, which will
cause the value of each unit of money (such as each dollar) to buy less in the
future. In some cases, hyperinflation makes the currency worthless. Even
countries do not last forever. Wars, natural disaster, bad economic policies,
revolution, coups, etc. can all destroy the value of the money itself.
As long as we live in an uncertain universe, a dollar today will always be
worth more than a dollar tomorrow. We should not expect to see banks abandoning
interest (even if they do not use the word) anytime soon.