Tag Archives: inflation

The time value of money

One of the odd things about this blog is that though I work in finance, I rarely write about it. Partly this is to keep my blogging life and my work life separate, but perhaps that separation is greater than it need be. Shortly, I plan on publishing my review of Karl Marx’s Capital. In writing that review, it became necessary to critique Marx’s dismissal of the notion of the time value of money. However, I recognise that not all of you are necessarily chartered accountants or have A-levels in economics. So you may not have heard the term before. If you have, and are aware of it, you may happily go about and read something else unless you want to pick my analysis apart. For those for whom the term does not mean something precise, then I hope this will sharpen up the concept in your mind, though I apologise if this comes across as patronising.

The concept of the time value of money should be one that you find fairly instinctive. I’ll demonstrate this with a few examples. Firstly, I offer to you a sum of money, let’s say £100. You can have that today, no strings attached. Or I could ask you to wait a week and then I would give you £110. Which is more valuable to you?

You have a choice between a smaller value or a greater value in the future. Can you wait for a week or is your need for the cash flow so great that you would settle for a smaller sum, effectively forfeiting £10?

Another trade-off would be if I offer you £100 now or £101 in ten years’ time. Which is more valuable to you?

I would hope that in the first case, waiting is the better option for you and that in the second case it is better to take the guaranteed sum now. Yet all this hinges on a level of subjectivity. It can vary from person to person or from business to business. The trick is to try to find an equivalent rate whereby the current value is equal to some future value. For example, if our choice was between £100 now and £105 in a year’s time, then would you “um” and “ah”, being unable to work out which is more valuable to you. If you put the money in a bank would you get a net rate of interest of 5%? If you could get more, then it’d more rational to put the £100 in the bank and get more interest, so at the end of it you have more than the £105 you might have had. If the net interest rate is lower, is there another way by which you could get a greater return in one year? If not, then your best bet is the £105 in a year’s time.

So the time value of money is expressed as an interest rate, being the rate that you would consider reasonable for a rate of return if given the opportunity to have a different sum at a future point in time.

One of the consequences of this is that higher interest rates are associated with higher levels of risk. You may have heard the phrase, “high risk, high return”, particularly if you’ve looked at choices for pension investments or if you think back to the global financial crisis of 2008, particularly with regards to the critique that the high risk aspect was ignored by the bankers whose actions played a significant part in precipitating the financial meltdown.

In my view, a part of the reason for this was that the fundamental subjectivity of the notion of the time value of money was forgotten by the systematic use of the Black-Scholes formula for options trading. That attempted to turn finance into a science which is a category error. Risk cannot be accurately quantified and it is a mistake to try to do so. Measures such as interest rates are indicative, so one looking at bonds can tell that a rate of 7% is riskier than one offering 2%. I know this personally quite well as I had considered changing my ISA some years ago and found the best rates of interest available to UK investors were to be found in Iceland. I even got so far as to the have an application form on my living room table. But I was suspicious about the high interest rates and, coupled with the relative devaluing of the Icelandic Krona against the Pound, I hesitated. Two months later those Icelandic banks collapsed. They were offering a high return because they were high risk investments.

The other aspect to think about is inflation. This is another reason why I stated at the top that the time value of money should be fairly instinctive, even if the term is new to some. Inflation is the creeping rise of prices of various goods, services and assets. If you have a fixed sum of money then it’s value decreases over time. In my childhood, £1 could buy you four packets of sweets with change left over. Years later, £1 might leave the shopkeeper asking for the rest of the money if you try to buy a single packet. So looking at cash as the arbiter of value is inherently flawed. What we can do is ask about what is known as present value.

What this does is look at future (generally fixed) payments and ask how much is the sum of those payments worth at today’s values. For example, the rent on my one bed, mouse-infested and rather cold flat is £11,700 per year. Let’s say that that rent doesn’t change for 10 years. Is the present value £117,000? No, because in 10 years’ time £11,700 will not be worth the same as £11,700 is today. I need to employ my subjective interest rate, my measure of risk, to do a calculation. Yet even that calculation will be assuming a constant rate of risk, but who knows what the future may bring?

If anything, that’s the point. The world of finance and of economics in general contain a great many unknowns. Those who would profess to declare with confidence exactly what will happen in the future are generally false prophets. Look out for this in the economic arguments in the general election. There, politicians from party Y will declare unanimously that if party X is elected then the economy is doomed whilst at the same time asserting with equally misplaced confidence that if they are placed in stewardship of the economy (though I doubt they have the humility to use the term stewardship) then all will be well. This will be on top of party X and party Y making promises on the other’s behalf.

I wouldn’t trust either who take such an approach to finance, but I would also warn against placing trust in finance in the first place. Believe me, I’m an accountant!

A Voter’s Manifesto (part 2 of 5)

Link to part 1

Environment

I note that David Cameron pledged to make this government the greenest ever. I also note that he has wholly failed to keep his promises. What is needed is not empty promises, but statutes which take seriously the fact that positive action for the preservation of the environment is not a hippy ambition but is necessary for the safeguarding of all people, now and in the future, with profound impacts on a great many other areas, not least the economy.

All legislation shall be subject to environmental review. If such reviews find that proposed legislation is not environmentally sustainable or does not mitigate to the maximum extent any potential harm, then it shall be rejected.

There will be no more investment into building new power stations that rely on fossil fuels. The only expenditure on them will be on safety.

Instead, investment will be made into renewable energies including, but not limited to, wind and wave power.

Such renewables may plug a gap left by the winding down of fossil fuels, but are not an answer to all our energy needs. So there should be funding into a new nuclear fission powered station, at a location yet to be determined.

Further to this, though, there should be additional funds made available to research into nuclear fusion as this is the cleanest, most fruitful potential source of energy available, but whose long-term feasibility remains a task that engineering has not yet conquered.

Recent years have seen annual floods in many parts of the country. This has partly been brought about by environmental change, but has been exacerbated by poor flood planning. I would propose a moratorium on building on flood plains. While there is a great need for new homes, not least in the form of social housing, these need to be built in areas where risks from flooding are minimal. There should also be additional funds directed to improving the flood defences in the areas that are routinely and severely hit.

Employment

Full employment is an ideal that should be aimed for but which should be acknowledged as unrealistic. Instead, there should be a recognition that there will likely be friction in the job market, but that the more realistic aim should be to keep unemployment to under 2 months per person.

Aiming for a total unemployment rate has less meaning than actually trying to get people into employment. So any unemployment statistics should be tiered to show the number who have been unemployed for less than 2 months, between 2 and 6 months, 6-12 months and over 12 months.

I have laid out before a measure to encourage companies to take on unemployed people before, so I would reiterate that policy.

No person should work for nothing. So work experience will have to become a form of paid employment. Zero-hours contracts should be outlawed as will the current Workfare programme.

Some additional measures are outlined in the Company Law section later in this manifesto.

Inflation measures

At present, the inflation measures that we use, RPI and CPI are artificially low. The reason is that they omit the very important factor of house price inflation. The RPI contains the increase in mortgage repayments, but if the interest rates are kept low (as a result of the current flawed inflation measures) then the RPI records a low inflation rate.

Instead, we should either amend the current measures or introduce a third which incorporates the rate of house price inflation. This would ensure the issue is taken more seriously than it currently is. There are currently some who are advocates of not increasing interest rates. When such people are put in charge of interest rates, then we get the divide that results in in house price inflation being up to 10 times what the RPI is in some locations.

It is my opinion that this is not good for long term economics and that it has fuelled the current housing bubble. Once we get a more realistic figure to use for inflation, then interest rates are almost certain to rise. While this will increase the cost of borrowing, this is necessary adjustment to correct some inequalities in our economy. Any further references to inflation should be taken to mean this improved measure which takes into account house price inflation.

Transport

Public transport is currently among the most expensive in Europe.

Train fares may be increased annually at a rate no more than inflation. This will not only apply in aggregate but will also apply to any given railfare anywhere in the country. So train companies will be prevented from increasing some fares by a little and some by extortionate amounts.

Rural bus services are also in need of improvement, so I would propose additional funding after a wholesale review has taken place, which should last no more than 2 years.

One of the major issues that is discussed in the construction of HS2, the high speed railway line. As yet, I am undecided on this issue, so offer no proposal either for or against it.

To reiterate a point made earlier, all legislation should be subject to an environmental review. Transport is one area that will be highly affected by this, not least when discussing airport capacity.

For any airline that operates at any UK airport, they will be required to engage in a carbon-offsetting programme to counteract the carbon dioxide emissions they make on all flights into and out of the UK, as well as internal flights. Airlines will be prohibited from passing on the cost of such an offset onto their passenger airfairs.

Healthcare

The current coalition government has embarked upon a dangerous crusade, based on a flawed ideology that market forces are the best way to ensure effective healthcare. As such, it should be the priority of an incoming government to repeal the Health and Social Care Bill.

The highest priority in the provision of front line services must be the wellbeing of the patient. Any would-be provider of such services should not be compromised by concerns over profitability, as this detracts from the highest priority. Therefore no provider of front line services may operate on a for-profit service. Any measures taken to privatise the NHS must be repealed and any care currently in private hands must be phased back into public hands over the course of the next parliament.

For any company that provides goods or services to the NHS (i.e. not front line service), the taxation on their profits should be ringfenced and directed straight back into the NHS. The reason for this is that healthcare should be prioritised over profits. So while it may be necessary for a company to generate profits to allow future investment, they should not be excessive, at the expense of the NHS.

Let’s give an example. Let’s say a company generates revenue of £30m, of which £20m is derived from the NHS. They make sufficient profits to warrant paying £3m of tax. While this tax would normally go into a central pot from the NHS would take part, 2/3rds of it should be directed straight into the NHS, with the other £1m going to the general pot.