One of the underlying assumption most people make is that on any investment or saving of money, there needs to be a (positive) interest rate. Why is that, why would it not be sufficient for anyone to put, say, 1000 $ in a bank savings account today and take it out after some 10 years to spend it on, for example, a new TV?
To answer that, we should look at the reasons why we do save and why do we invest at all.
Let’s tackle ‘saving’ first. You would only be able to save that amount of money that is not immediately needed to satisfy your basic needs, such as housing, food, clothing, basic health insurance, basic communication and some entertainment.
One reason to save, is to put money away into the safety of a bank account to be able to buy something in a year that you normally would not be able to afford (we leave credit aside for this discussion). Another reason to save is that to ‘insure’ yourself against rainy days, such as a job loss, salary decrease or retirement. The saved money serves, in other words, as a financial cushion to provide you with the standard of leaving you are used to. Savings in a bank account usually isn’t risky at all if you bank is FDIC insured. In that case, your savings up to 250,000$. Since savings accounts are not risky at all, they do not pay much interest.
If you are sure that you are saving enough to cover your future acquisitions or rainy days and still have money left, then you would be able to ‘invest’ that money. Investing is risky, that’s why there is in general a higher interest rate being paid for investments than for savings. Saying investments are more risky, is just another way of saying that you can lose all or part of the money you invested. It follows, that investment money should be seen as play money that you can afford to lose. If you are lucky you can put the additional money you make into your savings account to increase the size of your cushion.
We can now already see that interest rate on savings does not have quite the same significance as interest rate on investments. In savings accounts, there is no risk hence no or not much interest is being paid. In investments, there is risk. The higher the risk, the higher the interest rate.
Why then would you not be satisfied with zero interest rate on your savings since it is absolutely risk-free?
The answer is ‘inflation’. Prices, and thus the costs of living, will tend to rise through time due to inflation. Thus the 1000$ you put away today, will not buy you as much in ten years. Unfortunately, there is much insecurity at what this inflation rate will be over the years so saving still remains a bit risky. However, since your savings money is money you almost certainly are going to need, the inflation, which eats away at the interest rate, will be more significant than inflation eating away at your investment interest rate – remember the latter is money you don’t really need and that you can afford to lose.
It follows then that the higher the inflation, the riskier your investments must be to make up for the loss, otherwise your wealth will diminish over time. However, the riskier the investments the more likely you are to lose them.
Interest then, is strictly only necessary because of two factors, which are inflation and risk. We need to take a closer look at how inflation comes about.
I’ll do that in my next post.