Three Seemingly Disparate Observations

Observation #1:

In a page-one feature, The Wall Street Journal (5 October 2001) reported that “since the horrific events of September 11, a lot of Americans are reassessing their priorities … with the country on the verge of war and fear of bio-terrorism mounting, many are wondering what’s the point of being good anymore.” The article noted that diet and exercise programs are being abandoned, more of the hitherto abstemious are drinking and tipplers have increased both their intake and the time dedicated to imbibing. Further, more and more people like a New Yorker quoted in the article are “literally living each day like it is [their] last.”

Observation #2:

In a special report, The Wall Street Journal (5 October 2001) reported “many tens of thousands of people facing layoffs since September 11 are under-prepared. Even during the last decade of prosperity, many people failed – or simply weren’t able – to put away enough money for rainy days.” The report noted that rates of savings in the U.S. are meagre (in mid-2001 they stood at 1.1% of income on an annualised basis) and that consumers have accumulated large loads of debt (according to the latest figures, more than 14% of American households’ disposable income is used to service debt).

Observation #3:

According to Gallup (16 October 2001), “there are few signs that Americans have collapsed psychologically in the aftermath of the terrorist attacks of September 11, and in fact – to the contrary – [there are] many signs that the American public has rallied around its leaders and government and now has a significantly more positive spirit and optimism than before … This so-called ‘rally effect’ is among the most extraordinary findings in polling history.” Gallup noted that approval ratings for the President, Congress and their expenditure proposals are at very high levels; the extent of the public’s trust and confidence in the government to handle both international and domestic affairs is unprecedented; and there are few signs that over the past couple of months Americans’ perceptions economic conditions have deteriorated. These seemingly-unrelated observations implicitly describe clusters of behaviour which in some instances have become more acute since 11 September but which have been present to greater or lesser extents for years. They have a common underlying cause of enduring significance: Americans (and, it is reasonable to assume, Australians, Britons, Canadians and others) presently have very high time preferences. It is not so much that they are confident about the future; rather, they are complaisant about the likelihood that high-spending habits and lifestyles acquired over the past decade or so can continue indefinitely. Hence they continue to consume today (or insist that their governments feed them today) and are loathe to delay gratification and to restrict consumption today in order to maintain it into the future.

This series of circulars sets out what seems under present conditions (detailed in other circulars such as Interest Rates, Corporate Debt and the Business Cycle, The ‘New Economy’ and ‘Tech’ Stocks: Speculators Still Don’t Get It and A New Financial Year and a Renewed Case for Caution) to be an incompatibility between the only-partly-real material prosperity of recent years and the gilded values and policies that have accompanied it. In short, the maintenance of present standards of living (to say nothing of their improvement) requires much lower time preferences and much higher rates of savings than have been in evidence in recent years; and the tension between complaisant expectations of a secure future and an unwillingness to save for it (to say nothing of a rainy day) must resolve itself in either lowered expectations, greater savings or some combination of the two. Hence the incipient Distemper of Our Times. The Robinson Crusoe Ethic – a willingness to forego significant current consumption, trim one’s expectations and both accept and undertake entrepreneurial risk (in the proper sense of that phrase) in order to secure one’s future – is one means of redressing this Distemper. If they are not mitigated, then the Distemper’s embryonic effects may become more apparent; and to the extent that it remains undiagnosed and untreated its insidious effects may become malignant. Part I sets out the provenance and definition of the main concept, time preference, we require in order to shed this unconventional light upon these matters. Part II and Part III, which borrow heavily from Chap. 3 of T. Alexander Smith’s excellent book Time and Public Policy, explore the beneficial consequences of low time preference and the unpleasant consequences of high time preference. Part IV describes and celebrates the achievements of The Robinson Crusoe Ethic, and Part V offers a diagnosis of and prognosis for the emerging Distemper.

A Forgotten (or Oft-Denigrated) Starting Point

Eugen von Böhm-Bawerk (1851-1914), on three occasions the finance minister of the Austro-Hungarian Empire, was one of Europe’s most renowned economists at the turn of the twentieth century. Most notably, he contributed greatly to the theory of capital, interest and economic growth. His most significant work, Capital and Interest (vol. 1, 1884; vol. 2, 1889; 3-volume compendium, 1909-14), forms a basis of the modern theory of growth; further, Karl Marx and the Close of His System (1896) ranks with Ludwig von Mises’ Economic Planning in the Socialist Commonwealth (1921) as one of the most devastating from-first-principles refutations of market interventionism and state planning.

In most respects, however, Böhm-Bawerk’s insights have either been forgotten or belittled by today’s politicians, bureaucrats, academics, investors, employees, consumers and taxpayers. This is because the contemporary mainstream remains (whether subliminally or explicitly) strongly influenced by the ideas of Lord Keynes; because Keynesians laud expenditure by individuals, businesses and governments, denigrate savings and thereby de-emphasise the process of capital accumulation; and because during a period when popular antipathy towards frugality first appeared, Böhm-Bawerk was a prominent defender of private savings, entrepreneurship and investment. Not only did Böhm-Bawerk contend that increased savings neither harmed businesses nor attenuated economic activity: he showed that if savings were profitably invested, then they would promote growth and prosperity well into the future. Productive savings by businesses and individuals, then, is a necessary condition of capital formation; and the formation of productive capital is a sine qua non of higher material standards of living. Following Böhm-Bawerk’s lead, and extending and elaborating it in various ways, contemporary Austrian School economists have argued consistently that a high rate of voluntary savings is a key to growth. Austrians criticise both Keynesians (who denigrate savings and maintain that the road to affluence is paved with high current consumption by individuals and governments) and monetarists (who emphasise that a slow and steady growth of the supply of money is a key determinant of growth). Austrians, then, promote what today is regarded by many as an archaic and even subversive notion, i.e., voluntary savings and the successful investment of those savings by individuals and firms – and neither inflation by governments nor current consumption by individuals or governments – is the key to long-term prosperity.

Time Preference

Time is a critical (and, alas, all too often ignored) component of economic decisions. It is an inescapable component of the choices individuals make between consumption today and consumption at various points in the future. Hence the importance of analysing decisions that entail trade-offs between benefits that occur immediately (and which enable consumption in the present) and those that take time to realise (enabling possibly-increased consumption in the future). Proponents of mining, infrastructure and other projects, for example, often make claims such as “this project will cost $20 million today but will generate $50 million of benefits over its life span.” Assuming that these figures are accurate, whether the project is viable depends upon the alternate uses of the $20 million. It also depends upon the length of the project’s life span. A return of $30 million in net benefits after the initial investment of $20 million is recouped may be judged excellent if the benefits are received within five years; but if one must wait 20 years to recoup the investment and receive the benefits, then investors may conclude that the project is unlikely to justify its present opportunity cost. Income-producing assets, then, have time value and individuals have time preferences.. This second phrase means that most people would prefer to have cash (or assets or consumption goods, etc.) in hand today than a promise of cash in the future. If you were given the choice of receiving $100 now or waiting one year to receive it, for example, then you would probably prefer to receive the money immediately. Conversely, if you owed me $100 and had a choice of paying today or in a year’s time, then it is likely that you would prefer to wait.

At least three reasons rightly predispose people to believe that, other things equal, cash in hand is preferable today (or in the near future) than tomorrow (or the distant future). Consider first the effects of inflation. Nobody can predict its rate with certainty; accordingly, if it turns out to be greater than zero, then the purchasing power of a dollar in the future will be less than what it is today. If so, then it is clearly better that the creditor take the money today rather than tomorrow (or, if you are a debtor, to repay tomorrow with less-valuable dollars). Next consider risk. The promise of cash, assets or goods in the future is just that: a promise. But what is the likelihood that the person who makes the promise dies, defaults, absconds, etc., before you can redeem it? Given any amount of risk, the expected value of a dollar in the future is less than it is today; again, better for the creditor to take the money now rather than later (or, if you are a debtor, to repay later and hope in the interim that the creditor falls under a bus). Finally, consider the individual’s convenience and flexibility. If you accept the promise of cash at a particular day in the future, then until that day arrives you cannot reallocate the money to some other (perhaps more profitable) use. The promise, like the decision to accept it, is thus inflexible; and in the event that more attractive opportunities arise in the meantime, it is also inconvenient.

Time Preference and the Rate of Return

Given assets’ time value and individuals’ time preference, individuals require an inducement, i.e., an expected positive rate of return, in order voluntarily to forego consumption today and incur the risks (i.e., inflation, default, inconvenience, etc.) that inhere in investment. What is a reasonable rate of return? To answer this question, turn to the actual behaviour of borrowers and lenders. Is there some compromise rate of return at which some people (creditors) are willing to forego the use of money today in exchange for the right to receive a specified greater amount in the future, and at which other people (i.e., debtors) are prepared to enjoy the use of the money today in exchange for the obligation to provide a specified greater amount in the future? At this compromise rate of return some people will lend and others borrow. The rate of return to which borrowers commit themselves is the cost of undertaking current consumption which is otherwise beyond their means; and this same rate to which lenders commit themselves is their reward for delaying the consumption they could otherwise afford today. In reaching this compromise rate of return, participants undertake their own time preference calculations. Lenders, for example, determine what must be sacrificed now in order to obtain the expectation of a particular stream (or lump sum, etc.) of future benefits. Equivalently, lenders compare the satisfaction they must forego today to the satisfaction derived from the additional purchasing power they expect to receive at a specified point, interval, etc., in the future. Lenders who discount more heavily, i.e., are less willing to forego current satisfaction in anticipation of future benefits, are less certain that the benefits will eventuate, etc., require more substantial rates of return in order to induce them to part with their money. The higher the rate of return demanded, the higher the implied time preference.

Consequences of Long and Short Time Horizons

Time preference, then, refers to the innate desire for consumption and satisfaction in the more immediate as opposed to the more distant future. It is the preference for the sooner to the later. Many factors act upon one another in complex ways to influence the ratio of demand between present and future consumption goods. For example, among individuals or in a nation where thrift is highly regarded, the willingness to bear entrepreneurial risk is great and inconvenience is borne stoically, time preferences are relatively low. Conversely, where the demand for current consumption heavily outweighs the willingness to forego some consumption today in return for the prospect of more consumption in the future, and where there is a strong aversion to risk and inconvenience, time preferences are high. From these varying time preferences follow fundamentally different patterns of behaviour and results.

...continued in Part II