§9. Discounting is Fundamental

But although the rate of interest may be used either way—for computing from present to future values, or from future to present values—the latter process (discounting) is by far the more important of the two. Accountants, of course, are constantly computing in both directions; for they have to deal with both sets of problems. But the basic problem of time valuation which Nature sets us is always that of translating the future into the present, that is, the problem of ascertaining the capital value of future income. The value of capital must be computed from the value of its estimated future net income, not vice versa.

This statement may at first seem puzzling, for we usually think of causes and effects as running forward not backward in time. It would seem then that income must be derived from capital; and, in a sense, this is true. Income is derived from capital goods. But the value of the income is not derived from the value of the capital goods. On the contrary, the value of the capital is derived from the value of the income. Valuation is a human process in which foresight enters. Coming events cast their shadows before. Our valuations are always anticipations.

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These relations are shown in the following scheme in which the arrows represent the order of sequence—(1) from capital goods to their future services, that is, income; (2) from these services to their value; and (3) from their value back to capital value:

Not until we know how much income an item of capital will probably bring us can we set any valuation on that capital at all. It is true that the wheat crop depends on the land which yields it. But the value of the crop does not depend on the value of the land. On the contrary, the value of the land depends on the expected value of its crops.

The present worth of any article is what buyers are willing to give for it and sellers are ready to take for it. In order that each man may logically decide what he is willing to give or take, he must have: (1) some idea of the value of the future benefits which that article will yield, and (2) some idea of the rate of interest by which these future values may be translated into present values by discounting.