The Time Value of Money

We often hear the phrase "the time value of money," but what does that actually mean? Fundamentally, it means that money now is "worth more" than money later. For example, if I were to put $100 in a savings account at 1% interest, I would have $101 (not including compounding) at the end of a year. How can that be? How does money get more valuable?

It doesn't. The money itself, when there is no inflation or deflation, retains its original value. In order for there to be any return to money invested, it must be put to work. The only way money can be put to work is by using it to help transform one thing into another thing that is more valuable.

For example, if I take $100 to buy 100 plain wooden blocks and some paint, then invest my time painting the blocks for decorative purposes, I can sell them for, say, $120. The "extra" $20 is the result of my ingenuity and effort. I take cash, some raw materials, and my time and combine them to create value that did not exist before.

If I have an idea for creating such a product, but do not have enough cash on hand to purchase the plain blocks and paint, I cannot create value. A banker or someone else that lends money might recognize my idea as valuable and offer to lend me the money. Say I borrow $100 and agree to pay the lender $105 at the end of a year. I still make $15 on the enterprise. The bank also made money--$5.

This brings us back to our original example--the 1% return on a savings account. For nothing more than the trouble of depositing money in the bank, it pays me 1% It can do so only because it then takes my money and loans it out for 5% It can do that only because someone is willing and able to take that money and create more than 5% value with it.

Now, who makes the most money? We can figure this out by reasoning that a bank will never make money if it lends it out for less than it pays depositors. So the owner of the savings account necessarily makes less money than the bank. What about the business owner? If he/she makes less than the interest rate paid to the bank, that business is a losing proposition. In other words, the business has to make a 5% return just to break even.

This is of course a drastically simplified description of rates of return. The point is that the business owner has the greatest potential of making money. Note that I said potential. Business ownership entails risk, but it is essential for there to be a return on that $100 at all.

Whenever we invest our money, it provides us a return. Behind that return, there is a business, or multiple businesses, actually doing the work of creating value. If the investment is stable and strong, it can be a good strategy for providing for the future. It will never match the potential of a self-owned business, though, because too many other people take their cut first.

Wouldn't you rather get the biggest cut on at least some of your income? I would, and I'll bet you would too. Don't wait, start learning now.

Why Your Goals Don't Work

Yesterday, I assigned my students a voluntary overnight project. We had discussed goal setting in class and I wanted to impress upon them the importance of writing down and prioritizing their goals. As I generally find in my classes, only a small number did the whole exercise.

I already know why many of my students failed to follow through on this well-established method for getting what we want out of life. It is the same reason many of us fail to follow through. We say we want to achieve great things, but in the end, we would really rather stay in our comfortable cocoon of low-level misery.

We know from well over a thousand studies that goals work--that is, they lead to high performance. If you want to lose weight, make more money, or achieve anything else quantifiable, goals are the way to do it. Yet we all know how easy it is to get distracted while working on a goal. Why is that?

In my view, there are two major reasons we find it difficult to achieve things. The first stems from what I call a "mind-split." On the one hand we want to accomplish what we set out to do. On the other, we are afraid that we just might succeed. If we succeed, we show ourselves and the world that we really are capable. It renders null and void all the excuses we used before, and by implication, the excuses we may want to use in the future.

The second hindrance to goal achievement is having the wrong goals. High performance does not necessarily lead to happiness and personal fulfillment. I see this in "achievement junkies," people who crave the next chunk of conspicuous wealth or yet another trophy in a sport they have grown to despise.

Learning the mechanics of goal setting takes twenty minutes. Learning to set the right goals may take twenty years. As you set out on the great journey that is entrepreneurship, remember that getting what you really want is scary and that getting what you think you want may make you miserable.

Is This Socialism?

In order to understand the premises of socialism, we need to understand two words: "from" and "to." Specifically, socialists believe that justice is served when societies observe the following rule: From each according to his abilities; to each according to his needs.

On the face of it, this sounds just. Who would quarrel with the idea that people should get what they need? It is the "from" part that get us into trouble. If life were a matter of us all standing around a pre-existing barrel of goods--food, clothing, shelter, and other necessities--and taking what we needed, one might justify this distribution rule.

Of course, we all know that is not how the things we human beings need come to exist. Except for air, basic necessities have to be created by someone. Socialism presumes it is right to take from the creators and give to others. Is that what our economic system has become?

You bet it has, but not in the way you may think.

The complexity of our economic system has allowed us to take from people who don't exist yet. How can that be? It is called debt. Debt is en extremely useful tool. If someone lends you money to buy something you could not purchase with cash, say a house, many people benefit. You benefit because you are able to use something valuable before you pay for it completely. The seller benefits because he/she can sell to someone who otherwise could not purchase. The lender also makes money.

If we had no system for borrowing and lending money, it would be nearly impossible to own anything like a house or car. Here is the problem. Not only can regular people and private businesses borrow money, so can the government. The difference is that the government borrows from future generations.

One way the government does this is to borrow money literally. It essentially issues IOUs to its citizens. The government can also print money. In the first case, debt can build until the present generation cannot pay it all off. In the second, government spends money it has "printed" and hopes no one notices that the resulting inflation has robbed citizens of buying power.

Either way, the system makes chumps of us. If we live frugally, save our money, and teach our children to do the same, we wind up feeding the government's insatiable appetite for spending at our own expense. At some point, the system has to break down. Either our children and grandchildren will have to pay absurd tax rates or the value of our currency will diminish to zero. Maybe both.

And this brings us back to socialism. If the government tried in the present to take the amount of money it needs to sustain its orgy of spending, citizens would revolt. If they hide their theft by passing it on to its future citizens, we who are right here right now may grumble, but we won't revolt.

Is this how we want to live? If so, let's be honest about it. Socialism advocates taking from the "able" and giving to the "needy." If you believe that, are you willing to look future generations in the eye and tell them that we gave and gave and gave and that by the way, they owe the bill?

I didn't think so.

Truth or Consequences: Holding Big Business Accountable

When you or I start a business, we do not usually have the luxury of picking up the phone and calling our Congressman. Imagine actually getting through to your representative and having this conversation:

Noel: "Congressman Smith, this is Terry Noel."
(Smith motions to his Executive Assistant, shrugs his shoulders, and writes a note asking who the hell this guy is.")
Congressman: "Larry! Great to hear from you! You know, I am doing everything I can to stop global warming, guard against the swine flu, and get steroids out of baseball."
Noel: "Well, Congressman, that's not really why I called."
(Smith motions again. Writes a note asking for the caller's record of campaign contributions.)
Congressman: "Nothing?"
Noel: "Huh?"
Congressman: "What? I mean, nothing is more important than my constituents."
Noel: "Well, you see, I have a big problem. My business is coming up short this quarter. To tell you the truth, I could use a bailout."
Congressman: "I see..."
(Circles his finger at the side of his head in a cuckoo motion.)
Noel: "Not much. I mean nothing compared to the big banks."
Congressman: "Well, Harry, it's been nice talking to you and I appreciate your vote."
Noel: "Wait! The bailout?"
Congressman: "Yes, I am making sure that all these companies are held accountable. I am glad you support me. American jobs for American workers. That's what I say. We can't let our businesses suffer because of low wages in Fiji. Call again. Anytime."
Noel: "But...(click)...

When government injects itself into the economy, its actions are arbitrary, capricious, and usually based on campaign contributions. As long as politicians are given the power to reduce competition through regulation or provide subsidies outright to their contributors, businesses can grow. In fact, they can grow rapidly because they no longer have to work as hard to satisfy their customers. When things get rough, they ask their political friends to change the rules instead of competing fairly. Businesses don't get winnowed out for failure to perform.

The winnowing process of a truly free market is supremely neutral. If you or I do not provide a better product or service than our competitors, we lose money. If we lose enough, we go out of business. The only way to stop the current insanity of propping up businesses that are "too big to fail" is to take away politicians' power to interfere.

Thanks, Mr. President

No doubt hearing the cries of Tea Party attendees last week, President Obama bravely slashed $100 million dollars from the budget. $100 million dollars is a lot of money. That is, unless you compare it to the rest of the budget. Let's do some math. At least seven or eight trillion dollars has been created and injected into the economy. My calculator won't go that high, so I got out a big piece of paper and starting dividing. It turns out that it is 1/70,000 or .00001.

My first reaction was laughter. I thought I had accidentally stumbled upon The Onion web site. Nope. Turns out it was legitimate news. I had to ask myself, "What kind of nation have we become that we allow our leaders to insult us so roundly?"

Of course, we know exactly why Obama is doing this. It is to take our minds off what he and the rest of the government (our government) are not telling us about the financial crisis. When the truth comes out, will we fall for yet another cynical ploy like this one?

By Land or by Sea?

Paul Revere made his famous midnight ride to warn the countryside of an attack by the British. He asked his friend, who was to be in the North Church tower, to light one lantern if the attack was by land, two if by sea. Seeing the first light flicker in the belfry, he leaped astride his horse and whirled to take one more look. A second flame! The attack would be by sea and Revere set out at a thundering gallop to take his place in history.

I wish we had someone in a tower who could look and listen for the shuffle of British feet manning the boats on shore. We are not so fortunate, though. We know only that our nemesis--an economic meltdown--is lingering in the dark, waiting to attack like our oppressors of that time. Whether it comes by land or by sea, we do not know.

In a sense, all of us are looking toward that tower. Like the Americans of Revere's era, we have endured the harassment and insults of arrogant and incompetent tyrants. We know the big attack is coming, but from where? Deflation? Inflation? A major depression?

Our leaders think that injecting trillions and trillions of dollars of paper money into our economy will keep the enemy at bay. It may, for a while. In the end, though, the bill will come due and the unholy legions will come calling. When it does, where will you be? Asleep in bed armed only with a sheet of paper money or in a financial fortress built of solid knowledge and sound discipline?

Wake up, my friends. Midnight is upon us.

Uncovering Your Hidden Value

All business operates on a simple premise. One person creates value for another. Outside of gift-giving and other types of benevolence, the creator gets paid. He or she receives value, often in the form of money, and both partners to the trade are better off than they were before.

Many forms of value are obvious. Clothing, shelter, food, and the people who create them are valuable because we need those basic things to survive. Music, paintings, sports and other non-essentials improve our lives even though we could live without them. But they too are commonplace and obvious.

Many people who start businesses are stuck in the obvious. They try to provide more of what others are already providing quite well: dry cleaners, groceries, web design, etc. There is nothing wrong with opening this kind of business. If you can do it better, faster, or cheaper than your competitors, you may do well. But why butt heads with the rest of the market?

Each of us has value to others that may have gone unrecognized. We may know how to do something unique or make something unusual that is valuable to 0thers. But how does one discover these hidden veins of value? Start by brainstorming fifty ideas for businesses. Don't criticize or question any idea, just write down fifty. Even if some turn out to be "obvious" keep writing. Chances are, you will find something valuable that only you can provide.

The next step is refining your idea into a business model. A business model takes your initial idea and builds around it a "delivery system" that allows you to get paid for what you do well. More on business models next post.

What is Money?

If your answer is the green stuff in your wallet or purse, go to the back of the line. The paper we all carry is a facsimile, a representation--a marker, really, for real money. It is fake. It works well in the place of real money, but only under certain conditions.

The idea behind money itself is brilliant. We can imagine how the first humans developed the barter system--you make arrows better and I make blankets better. Hmmmm...maybe we could trade and both be better off. Free trade ranks as one of humanity's crowning achievements. As we grew in intelligence and sophistication, the barter system became cumbersome. If you did not happen to need blankets at the same time I needed arrows, we were out of luck.

Money was invented to "mark" an asynchronous exchange of value. That is just a fancy way of saying that one of us could store the value he/she had created for future use. Neat idea, huh? The only problem was what to use for a marker.

Not just anything would do. In order for something to serve as money, it had to be durable, portable, and rare. Durability allowed value to be stored safely. No good using a tree leaf if it disintegrates before it can be spent. Portability allowed the value to be transported over large distances, thus expanding trade to the benefit of all. Those two characteristics are fairly obvious, and real money over the course of human history has nearly always been durable and portable. But why rare?

Rareness is a desirable characteristic for money to have because it needs to represent the value that is created and stored by the holder. If we were to use any old seashell, everyone could become rich by going to the beach. Something is wrong here, though. How can everyone become rich by picking up seashells? The answer is, they can't, though our government believes they can. This is the primary reason we are all facing the biggest financial crisis in decades.

Money is not usable. We can't eat it, can't wear it, and can't cure disease with it. What we want is the value behind it. If I am sick, the only reason I want money is to purchase your services as a physician. That seashell is worth only what I can trade it for. If the supply in a particular economy (let's say a village) gets too high, its value goes down. Soon it takes a bushel basket full of shells to purchase what three shells would purchase before.

The reason shells become worthless is that anyone can get them without providing any tangible value to anyone else. Over thousands of years, two main materials have emerged that prevent such flagrant abuses of the idea of money--gold and silver. Yes, some people acquire wealth by digging up gold or silver, but it is a lot of trouble and the supply is limited. In a sense, the miners of precious metals earn their value by providing the rest of us with a solid standard of exchange.

Gold and silver became the only real money not because anyone decreed them to be so, but because people in general recognized them as money. Governmental interference came much later, mostly with undesirable consequences.

Today, our government is creating currency hand over fist. All this in the name of "saving the economy." Note that I said "currency," not money. Did you ever wonder where that now nearly one trillion dollars comes from? They create it out of thin air. It represents no tangible value whatsoever. Like the village I just spoke of, our politicians are going to the beach, gathering shells, and calling it money. Oh, and they force us to use it as money. That is why you see "This note is legal tender for all debts, public and private" on our currency.

Our nest eggs all got hammered last year because we were counting on currency. We all thought that we would be able to trade what we thought was money for things we will want and need when we retire. Not likely. If your portfolio was mostly stocks, bonds, and mutual funds, you have been had. If you thought that Social Security would allow you to at least buy food and shelter and that Medicare would pay your doctor bills, think again.

The good news is that we do not have to sit and take this. No, I do not mean storming Washington, much as I love to dream of that. I mean that living the life you want to live and being able to retire comfortably now requires more courage and savvy than ever before. Next week, I will explain why you must learn what assets are and how you can start creating them.

"I'm not dead yet." scene from Monty Python's Holy Grail

"In the long run, we are all dead." John Maynard Keynes

This ranks as one of the most irresponsible remarks in the history of humanity. Keynes may have filled his own prophecy. He is dead. We are not--at least not yet. But we are living in Keynes' long run and we are about to find out how wrong he was.

Keynesian economics called into question the premises of the classical theory that preceded it. Keynes thought that laissez-faire capitalism, the freedom of individuals to trade with little or no interference from the government, would lead to sub-optimal outcomes for the economy as a whole. He advocated a more aggressive role for government to counterbalance business cycles and to promote economic well-being through "stimulus" spending.

Little wonder that politicians embrace his message. Keynes' invitation to spend, spend, spend is like telling an alcoholic to drink, drink, drink. The only difference is that taxpayers get the hangover. A huge economy like ours is a hard thing to break. Because we have, at least up until now, retained enough economic freedom to entice bright people to create and sell things we all want and need, we have survived. Until last year, we even gave off the impression of having prospered. That is, until millions of retirees watched their portfolios implode. Welcome to the long run.

Many of us with limited-government sensibilities thought the last nail had been driven into Keynes' coffin two decades ago. As it turns out, he may drive the last nail into ours. Obama and his Democratic allies in Congress have conjured up his spirit, invoking heroic images of FDR, the imagined savior of the Great Depression. And lest you think this is a Republican-friendly blog, they are no better. If anything, they are more devious, pretending to prefer less government while spending like inebriated seamen. In a way, Democrats are the streetwalkers of American life. They don't pretend to be anything but what they are or they are too stupid to hide it. Republicans are call girls, cleverly pretending to be respectable, but eager to go spread-eagle for a slightly higher fee.

No amount of ranting about politicians, cathartic as it may be, will help any of us. The system has been rigged over a period of decades and is now beyond repair without radical changes. Don't hold your breath waiting for politicians to learn anything. What will help us as individuals is a realistic preview of what is about to happen and how to protect ourselves. This time, folks, it is different. We are beyond arguments about what government should do. We are about to find out what they cannot do.

Welcome to Empty Nest Egg

Welcome to the first in a series of posts on the topic of our current financial crisis. I teach entrepreneurship at the university level and have spent a large amount of time researching and thinking about how and why people start businesses. Some want to, perhaps because they do not like working for someone else or they hate working by the clock. Others are interested in achieving great wealth, something that is next to impossible with a job.

The events of 2008 have created another compelling reason to start a business. Many of us will simply have to. Though I am at my core an optimist, I believe that we have reached a tipping point. In the blink of an eye, we have seen the imminent collapse of our largest financial institutions, insurance companies, and automakers. Job layoffs are increasing rapidly, as are foreclosures. It is not pretty and it will get worse.

My purpose in writing this blog is twofold. First, I want to offer my interpretation of these disturbing events. The mainstream press has done an abysmal job of exposing the real culprits in our descent into economic madness. Second, I want to offer readers a way out. While the next few years are going to be a rough ride, those who are willing to learn some basic business skills and to question their previously held assumptions about the relationship between government and the economy have the opportunity not only to survive, but to prosper in the coming years.