Development Roast

Save First - Consume Later

"Money often costs too much."
Ralph Waldo Emerson

If children were to learn just one thing in school, it should be The Power of Compound Interest. If everybody understood and applied that simple principle, poverty could be permanently eradicated in one life-time.

Let me explain how it works by comparing two persons, A and B, who, for simplicity, both live for 100 years.

Person A saves 1 boliviano every day for the first 60 years of his life and invests the savings at an average real return of 6% per year. By the time he is 60, he stops saving and instead starts withdrawing 30 bolivianos every day for the rest of his life (40 years). By the time he dies, he will leave his children a nice little nest egg of close to half a million Bolivianos (430.718 to be exact). The total amount he saved was 1*365*60 = 21.900 bolivianos, whereas the total amount withdrawn for consumption and inheritance was 30*365*40 + 430.718 = 868.718 bolivianos. Due to the Power of Compound Interest, he could consume 40 times as much as he saved, because he did the saving first.

  In contrast, person B saved nothing for the first 30 years of his life and then he borrowed 100.000 bolivianos to finance a house (at 8 percent real interest). He immediately started paying back that loan with 20 bolivianos per day, and he kept paying that amount till the day he died 70 years later. In total he consumed 100.000 bolivianos worth of housing, but he paid 20*365*70= 511.000 in debt payments and left a debt of 2 million bolivianos to his children. Due to the Power of Compound Interest, he had to save 15 times more than he consumed, because he did it in the wrong order.

Notice that anybody can save 1 boliviano per day, even a shoe shine boy or a beggar. It is just one extra pair of shoes to shine or one less beer Friday night. In contrast, paying 20 bolivianos per day is not nearly as easy, as that is close to the average daily income in Bolivia.

Notice also that the interest rates in the examples above are very conservative. You could easily earn a higher return, or pay a much higher interest on your loan. In that case the difference between the two persons would become even more pronounced.

So timing is everything if you want to be rich. If you save first, you will be richly rewarded. If you consume first, you will pay dearly.

If you think credit is the answer to Bolivia's problems, you might want to think twice.

P.S: If you are not a shoeshine boy and not a very young child, you might want to go for one dollar per day instead of one boliviano per day.

(*) Director, Institute for Advanced Development Studies, La Paz, Bolivia. The author happily receives comments at the following e-mail: 1.