The Misesian Case against Keynesianism is based partially on the idea of time preference (for a fuller explanation of the case, read the whole article here from which this is excerpted). Time preference theory posits that each person has a natural inclination toward a personal choice in the amount of money one will spend versus save. This choice is based around a more general principle, that individuals have natural inclinations toward acting for the future or acting in the present with little regard to future implications. The theory says nothing of the morality of that inclination, rather that the inclination and choices that spring therefrom should be left to the individual. Government fiscal policy does not do this, and increases the time preference for all of us. I will let Hoppe take it from here, and explain how central planning cannot account for that praxeological truism. Bear with me on this one. It starts boringly, but the societal implications are widespread:
The holding of money is a result of the systemic uncertainty of human action. Interest rates, on the other hand, result from time preference, which is as essential to action as uncertainty. In acting, an actor not only invariably aims to substitute a more for a less satisfactory state of affairs and so demonstrates a preference for more rather than fewer goods; he must also invariably consider when in the future his goals will be reached (i.e., the time necessary to accomplish them) as well as a good’s duration of serviceability; every action thus also demonstrates a universal preference for earlier over later goods and for more over less durable ones. Every action requires some time to attain its goal; since man must consume something sometimes and cannot ever stop consuming entirely, time is always scarce. Thus, ceteris paribus, present or earlier goods are, and must invariably be, valued more highly than future or later ones.
In fact, if man were not constrained by time preference and the only constraint operating were that of preferring more over less, he would invariably choose those production processes that would yield the largest output per input, regardless of the length of time needed for those methods to bear fruit. For instance, instead of making a fishing net first, Crusoe would immediately begin constructing a fishing trawler, as the economically most efficient method for catching fish. That no one, including Crusoe, acts in this way makes it evident that man cannot but “value fractions of time of the same length in a different way according as they are nearer or remoter from the instant of the actor’s decision” (Mises  1966: 483).
Thus, constrained by time preference, man will exchange a present good against a future one only if he anticipates thereby increasing his amount of future goods. The rate of time preference, which can be different from person to person and from one point in time to the next, but which can never be anything but positive for everyone, simultaneously determines the height of the premium that present goods command over future ones as well as the amount of savings and investment. The market rate of interest is the aggregate sum of all individual time-preference rates, reflecting, so to speak, the social rate of time preference and equilibrating social savings (i.e., the supply of present goods offered for exchange against future goods) and social investment (i.e., the demand for present goods capable of yielding future returns).
No supply of loanable funds could exist without previous savings, that is, without abstention from some possible consumption of present goods (an excess of current production over current consumption). And no demand for loanable funds would exist if no one were to perceive any opportunity to employ those funds, that is, to invest them so as to produce a future output that would exceed current input. Indeed, if all present goods were consumed and none invested in time-consuming production processes, there would be no interest or time-preference rate. Or rather, the interest rate would be infinitely high, which, anywhere outside of the Garden of Eden, would be tantamount to leading a merely animal existence, that is, of eking out a primitive subsistence by facing reality with nothing but one’s bare hands and only a desire for instant gratification.
“The holding of money is a result of the systemic uncertainty of human action. Interest rates, on the other hand, result from time preference, which is as essential to action as uncertainty.”
A supply of and a demand for loanable funds only arises — and this is the human condition — once it is recognized that indirect, more roundabout, lengthier production processes can yield a larger or better output per input than direct and shorter ones; and it is possible, by means of savings, to accumulate the number of present goods needed to provide for all those desires whose satisfaction during the prolonged waiting time is deemed more urgent than the increment in future well-being expected from the adoption of a more time-consuming production process (Mises  1966: 490ff).
So long as this is the case, capital formation and accumulation will set in and continue. Instead of being supported by and engaged in instantly gratifying production processes, land and labor, the originary factors of production, are supported by an excess of production over consumption and employed in the production of capital goods, that is, produced factors of production. These goods have no value except as intermediate products in the process of turning out final (consumer) goods later. Production of final products with the help of these goods is more “productive.” Or, what amounts to the same thing, he who possesses, and can produce with the aid of, capital goods is nearer in time to the completion of his ultimate project than he who must do without them.
The excess in value (price) of a capital good over the sum expended on the complementary originary factors required for its production is due to this time difference and to the universal fact of time preference. This excess is the price paid for buying time: for moving closer to the completion of one’s ultimate goal rather than having to start at the very beginning. And for the same reason of time preference, the value of the final output must exceed the sum spent on its factors of production, that is, the price paid for the capital good and all complementary labor services.
The lower the time-preference rate, then, the earlier the process of capital formation will set in and the faster it will lengthen the roundabout structure of production. Any increase in the accumulation of capital goods and in the roundaboutness of the production structure raises, in turn, the marginal productivity of labor. This leads to increased employment and/or wage rates and, in any case (even if the labor-supply curve should become backward sloping with increased wages), to a higher wage total (see Rothbard  1970: 663ff). Supplied with an increased number of capital goods, a better-paid population of wage earners will now produce an overall increased-future-social product, raising at last, after that of the employees, the real incomes of the owners of capital and land.
While interest (time preference) thus has a direct praxeological relationship to employment and social income, it has nothing whatsoever to do with money. To be sure, a money economy also includes a monetary expression for the social rate of time preference. Yet this does not change the fact that interest and money are systematically independent and unrelated and that interest is essentially a “real,” not a monetary phenomenon.
Time preference and interest, in contrast to money, cannot be conceived of as disappearing even in the state of final general equilibrium. For even in equilibrium the existing capital structure needs to be constantly maintained over time (so as to prevent it from becoming gradually consumed in the even course of an endlessly repeated pattern of productive operations). There can be no such maintenance, however, without ongoing savings and reinvestments, and there can be no such things as these without the expectation of a positive rate of interest. Indeed, if the rate of interest paid were zero, capital consumption would result and one would move out of equilibrium (see Mises  1966: 530–32; Rothbard  1970: 385–86).
Matters become more complex under conditions of uncertainty, when money is actually in use, but the praxeological independence of money and interest remains intact. Under these conditions, man invariably has three instead of two alternative ways to allocate his current income. He must decide not only how much to allocate to the purchase of present goods and how much to future goods (i.e., how much to consume and how much to invest), but also how much to keep in cash. There are no other alternatives.
Yet while man must always make adjustments concerning three margins at once, the outcome is invariably determined by two distinct and praxeologically unrelated factors. The consumption/investment proportion is determined by time preference. The source of the demand for cash, on the other hand, is the utility attached to money (i.e., its usefulness in enabling immediate purchase of directly serviceable goods at uncertain future dates). And both factors can vary independently of one another.
As with other aspects of the real economy, the level of money stock has no effect whatsoever on the rate of interest, which is determined by time preference. But changes in the stock of money can not only affect relative prices and incomes, but also reduce overall real incomes by causing booms and busts or by dislocating the process of economic calculation.
Furthermore, since changes in the stock of money will necessarily affect the distribution of incomes, the social rate of time preference will be affected by the time preferences of the early, as compared to the later, receivers of the new money. But since there is no way of predicting whether social time preferences will rise or fall from any given change in the money supply, such changes can have no systematic effect on the rate of time preference and hence, on the rate of interest.
The same is true of changes in the demand for money and their effects on time preferences. If, for example, the Keynesian nightmare of increased hoarding becomes reality and prices generally fall while the purchasing power of money correspondingly rises, this will have no predictable systematic effects on the investment/consumption proportion in society. This proportion, and the time-preference schedule determining it, will change unpredictably, depending on the time preferences of the hoarders and non-hoarders and on how the changing demand for money ripples through the market economy.
In an unhampered economy, the interest rate is solely determined by the social rate of time preference (to which is added a premium, depending on the extent of risk involved in the particular loan). Since the real interest rate will tend to equal this social rate of time preference, expected price inflation will tend to be added by the market to the money interest rate, so as to keep the real rate equal to time preferences. The rate of interest on money loans will tend to be equal to the rate of return on investments, with this rate itself determined by the time-preference rate plus the inflation premium. But if the banks inflate credit, the increased supply of loans will temporarily drive down the loan-interest rate below the free-market rate, thereby generating the inflationary boom-bust cycle.
With the division of labor established and extended via development of a universal medium of exchange, the process of economic development is essentially determined by time preference. To be sure, there are other important factors: the quality and quantity of the population, the endowment with nature-given resources, and the state of technology. Yet of these, the quality of a group of people is largely beyond anyone’s control and must be taken as a given; the size of a population may or may not advance economic development, depending on whether the population is below or above its optimum size for a given-sized territory; and nature-given resources or technological know-how can have an economic impact only if discovered and utilized.
In order to do this, though, there must be prior savings and investment. It is not the availability of resources and technical or scientific knowledge that imposes limits on economic advancement; rather, it is time preference that imposes limits on the exploitation of actually available resources as well as on the utilization of existing knowledge (and also on scientific progress, for that matter, insofar as research activities too must be supported by saved-up funds).
Thus, the only viable path toward economic growth is through savings and investment, governed as they are by time preference. Ultimately, there is no way to prosperity except through an increase in the per-capita quota of invested capital. This is the only way to increase the marginal productivity of labor, and only if this is done can future income rise in turn. With real incomes rising, the effective rate of time preference falls (without, however, reaching zero or becoming negative), adding still further increased doses of investment and setting in motion an upward-spiraling process of economic development.
There is no reason to suppose that this process will come to a halt short of reaching the Garden of Eden, where all scarcity has disappeared — unless people deliberately choose otherwise and begin to value additional leisure more highly than any further increase in real incomes. Nor is there any reason to suppose that the process of capitalist development will be anything but smooth, that is, that the economy will flexibly adjust not only to all monetary changes but to all changes in the social rate of time preference as well. Of course, as long as the future is uncertain, there will be entrepreneurial errors, losses, and bankruptcies. But no systematic reason exists for this to cause more than temporary disruptions or for these disruptions to exceed, or drastically fluctuate around, a “natural rate” of business failures (see Rothbard 1983a: 12–17).
Matters become different only if an extra-market institution such as government is introduced. It not only makes involuntary unemployment possible, as explained above, but the very existence of an agent that can effectively claim ownership over resources which it has neither homesteaded, produced, nor contractually acquired also raises the social rate of time preference for homesteaders, producers, and contractors, hence creating involuntary impoverishment, stagnation, or even regression. It is only through government that mankind can be stopped on its natural course toward a gradual emancipation from scarcity long before ever reaching the point of voluntarily chosen zero growth. And it is only in the presence of a government that the capitalist process can possibly take on a cyclical (rather than a smooth) pattern, with busts following booms.
Exempt from the rules of private-property acquisition and transfer, government naturally desires a monopoly over money and banking and wants nothing more than to engage in fractional reserve banking, that is — in non-technical terms, monopolistic counterfeiting — so as to enrich itself at the expense of others through the much less conspicuous means of fraud rather than through outright confiscation (see Rothbard 1983a; Hoppe 1989a).
Boom-and-bust cycles are the outcome of fraudulent fractional reserve banking. If, and insofar as, the newly created counterfeit money enters the economy as additional supplies on the credit market, the rate of interest will have to fall below what it would otherwise have been: credit must become cheaper: Yet at a lower price more credit is taken and more resources then are invested in the production of future goods (instead of being used for present consumption) than would otherwise have been. The roundaboutness of the entire production structure is lengthened.
In order to complete all investment projects now under way, more time is needed than that required to complete those projects begun before the credit expansion. All the goods that would have been created without credit expansion must still be produced — plus those that are newly added. However, for this to be possible more capital is required. The larger number of future goods can be successfully produced only if additional savings provide a means of sustenance sufficiently large to bridge, and carry workers through, the longer waiting time. But, by assumption, no such increase in savings has taken place.
The lower interest rate is not the result of a larger supply of capital goods. The social rate of time preference has not changed at all. It is solely the result of counterfeit money entering the economy through the credit market. It follows logically that it must be impossible to complete all investment projects under way after a credit expansion, due to a systematic lack of real capital. Projects will have to be liquidated so as to shorten the overall production structure and readjust it to an unchanged rate of social time preference and the corresponding real investment/consumption proportion.
These cyclical movements cannot be avoided by anticipation (contrary to the motto “a cycle anticipated is a cycle avoided”): they are the praxeologically necessary consequences of additional counterfeit credit being successfully placed. Once this has occurred, a boom-bust cycle is inevitable, regardless of what the actors correctly or incorrectly believe or expect. The cycle is induced by a monetary change, but it takes effect in the realm of “real” phenomena and will be a “real” cycle no matter what beliefs people happen to hold.
Nor can it be realistically expected that the inevitable cyclical movements resulting from an expansion of credit will ever come to a halt. As long as an extra-market institution like government is in control of money, a permanent series of cyclical movements will mark the process of economic development; for through the creation of fraudulent credit, a government can engender an inconspicuous income and wealth redistribution in its own favor. There is no reason (short of idealistic assumptions) to suppose that a government would ever deliberately stop using this magic wand merely because credit expansion entails the “unfortunate” side effect of business cycles.
I will be sure to add this to Meet Me Halfway…
- Paul Krugman’s economics plays chicken with civilization itself, which would be destroyed utterly if he had his way.
- The Case Against the Flat Tax.
- The Case for the 100% Gold Dollar.
- Why Prices End with .99.