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Source link: http://archive.mises.org/11461/of-time-and-marshmallows/

Of Time and Marshmallows

January 15, 2010 by

The phenomenon of interest occurs because of the simple fact that, other things being equal, people prefer satisfaction sooner rather than later. This universal feature of acting man is called “time preference.” FULL ARTICLE by J. Grayson Lilburne

{ 36 comments }

Stephen Grossman January 15, 2010 at 11:10 am

Mark Skousen’s _Structure of Production_ contains amn excellent history of time in economic theory. The rationalizations for evading time are breath-taking. Keynsians, etc. are as self-destructive as drug addicts. They regard time, in effect, as a series of instants instead of as a flow. They are anti-ideological Pragmatists. Ayn Rand, in “Egalitarianism and Inflation,” stressed the importance of time in production.” She warned, in the 1970s, that America is consuming its capital. She read Mises, _Theory of Money and Interest_ and _Human Action_.

billwald January 15, 2010 at 12:14 pm

People who have tens of millions increase in personal assets every year are working for power and control, not for spending money. They will not work any less because of any tax laws.

I propose a 100% marginal income tax rate set at 1000 times the federal minimum wage. Someone please explain how this will destroy the American economy.

Fred January 15, 2010 at 12:35 pm

This is an excellent article – the author should be praised for the clarity of his exposition. I’ll be sending this one around to friends.

lvmienthusiast January 15, 2010 at 2:38 pm

Great article Lilburne!

Addressing Billwald…Your treatise is so flawed I don’t even know where exactly to start.

Basically, what you are really supporting is an exponential increase in federal receipts at the expense of the private economy. Probably to fund another glorious military incursion in Iran.

Thereby skewing the consumption-investment ratio and covertly making every individual that much poorer. While Paul Krugman and the like are prancing around screaming, “tax rates should be increased by 25% all across the board and if they had heeded my advice earlier we wouldn’t have been in this mess in the first place”.

I fail to see how your scheme is beneficial Billwald.

snargles January 15, 2010 at 2:55 pm

@ Bill

Why would we want to ever give money to the government ever!?!?!?

Are you insane? How much blood would you like on your hands?

I can get some sheep’s blood if that will suffice.

How will a marginal tax bracket of 100% of people with incomes of approx. $1,600,000 hurt the economy?

The question presumes that the American Economy hasn’t already been destroyed (which it has btw, by even less devastating measures)

Your answer:

By putting people with incomes of $1,600,000 in a 100% tax bracket, and by putting that much wealth destroying power in an organization that does nothing other than negate liberty and destroy wealth!

The reason why such measures would obliterate the economy is because income over $1.6 M by and large gets used investing in large capital endeavors that one day produce cheaper consumer products not unlike those you see at your grocer or neighborhood wal-mart. If there is no capital investment, there are no products. Read: Human Action.

Wow, Bill, seriously, visit this site often?

Nikola January 15, 2010 at 5:07 pm

Congratulations for the good article. I really like how it represents the Mises theory of time preference and business cycles.
However, for me they are not correct. I will try to explain why and hope that there might be some constructive discussion. I am particularly interested in investment and risk, and this interest lead mo to the following opinions.
1. Time preference
As the author claims: “The phenomenon of interest occurs because of the simple fact that, other things being equal, people prefer satisfaction sooner rather than later.” I agree that proably other things being equal, people in general prefer satisfaction sooner rather than later. But this doesn’t explain the existence of interest. First of all I think everybody should agree that when we speak about interest which is a result of a contract, the phenomenon of interest occurs because of the simple fact that the two parties agreed on it. The two parties might agree on an interest-free loan, or a loan with a negative interest. So we know for sure that interest occurs or doesn’t occur because of the free will of the two parties who make the contract. But I also don’t think that there is generally a time preference for goods sooner rather than later, and I will give examples.
In our time everyday are executed contracts worth trillions of dollars which are contrary to the idea that people prefer goods sooner rather than later. One example are futures and forward contracts. A futures on gold expiring on December 2013 costs now $1245.7, while the current spot price is $1130. If the theory of time preference was true, why would somebody be willing to pay $1245.7 for satysfying his needs for gold after 4 years, when he can satisfy his needs for gold now by buying it on the current spot price of $1130? And yet those contracts are traded in large amounts every day.
Another intriguing example are option contracts. They give the buyer the right, but not the obligation, to buy a certain good at a certain date at a certain price (called “strike”). So a put option on gold expiring on December 2013 with a strike price of $1130 costs $187. This option will give its buyer the right to sell 1 troyounce of gold after 4 years for $1130. If the theory of time preference was true, why would somebody pay $187 now for the right to sell his gold after 4 years, when he can sell it for $1130 today? And yet options are bought everyday in huge volume.
The author gives example with an experiment with 4-year old children and candies. But satisfaction of 4-year olds differs from decisions for saving and investment of grown-ups (at least I hope so). And the first examples of time preference for satisfaction through marshmallows differ from the examples of time preference for saving and investment which come later in the article. Let’s discuss interest when it comes to investment. Entrepreneurs don’t pay interest because they want to satisfy their needs earlier, but because they want to invest the borrowed money, for example in building a giant single-use trebuchet. They hope that their investment will earn them profit, which will be higher than the charged interest. I have to stress the word “hope”. This is what drives entrepreneurs to borrow money. But their hope means “risk” – if the investment is not profitable, they will be unable to repay the loan and will default on it. If Craig borrowed seashells to invest in building a giant single-use trebuchet, but unexpected fire burned the trebuchet during construction, he would have to file bankruptcy. Carolyn would not receive her money back.
So a possible reason why investors pay interest is the risk that they are not going to pay back. If this risk didn’t exist and the trebuchet was 100% sure to be built, Carolyn would be willing to give her seashells to Craig at 0% interest or even at negative interest. The reason for this is that she has storage costs and there is a risk that her seashells might be stolen or lost. So if she can find a riskless borrower, she would be willing to give him her money instead of paying for storage and insurance on them.
I have to point to one very important example of a case when people prefer goods later rather than sooner – pension plans. Millions of people allocate savings worth trillions of dollars which they do not want to consume now, but want to save for later consumption. And this example is equivalent to the example of any person who wants to save his money for later consumption. These people are faced with the problem how to do it and the problem is not simple. They can invest them or lend them, but these actions involve risk as I already showed. They can just keep their savings, but then they will have storage costs and bear the risk of theft or loss. And of course if we take into account Helicopter Ben, their savings will be diminished by inflation. So all these risks probably explain why people trade futures and options and are willing to pay more money for consuming goods later instead of now. If you buy a futures on gold expiring after 4 years, you will not incur storage costs and bear the risk of theft or loss. Generally futures and options are more expensive the farther their expiration date is, which contradicts the theory of time preference.
To sum up my points:
- Time preference is not always for sooner goods. There are millions of people who want to save resources for spending them later. Many of them will be happy to just save them without receiving any interest, but even this goal is hard to achieve, because of the storage costs and the risks of theft or loss.
- Investing involves many risks. The risk is probably the main factor determining the existence of interest.
- We have empirical evidence from the futures and options markets that market participants are paying higher prices for later rather than sooner consumption. This fact contradicts the theory of time preference.
2. Business cycles
First I want to give my own explanation for the “business cycles” and later compare it to Mises’ and Lilburne’s explanations. A business (also called a company, enterprise or firm) is a legally recognized organization designed to provide goods and/or services to consumers. Businesses are predominant in capitalist economies, most being privately owned and formed to earn profit that will increase the wealth of its owners and grow the business itself. The owners and operators of a business have as one of their main objectives the receipt or generation of a financial return in exchange for work and acceptance of risk. (source: Wikipedia). When running a business, there is a risk of default. A risk of default exists always, when the entrepreneur takes the obligation to pay something, which he doesn’t currently own. A classical example is the leverage. When using leverage, companies borrow money to increase their returns. But if their returns are negative, there is a possibility that they will be unable to repay their debts and will have to default on them. A nice illustration for a leveraged company is a bank with minimum reserves, let’s say 10%. In the US the highest rated bank holding companies are allowed to maintain a leverage of only 3% (!) – http://www.fdic.gov/regulations/laws/rules/6000-2200.html#6000appendixd.
The bank borrows money from depositors to increase its returns from lending money. If the depositors decide to withdraw 10% of their money, or the borrowers default on 10% of their debts, the bank will go bankrupt. So when a bank is leveraged i.e. lends or invests money which are borrowed, there is always the risk of default. If Carolyn doesn’t lend to Craig her own seashells, but borrows them from other islanders, in case of an unexpected fire which burns the unfinished trebuchet, Craig’s default on his debt will lead to Carolyn’s default on her debt to her “depositors”. And this is true for all leveraged businesses. So when a lot of businesses in an economy are highly leveraged, sooner or later some of them will go bankrupt, and if they are big, this might lead to many other bankruptcies. High leverage means high levels of debt, and if debt is to be repayed, the indebted business has to use some of the profits not for new investments, but for repayment of debts. This will decrease productivity of this particular business. If the businesses in the economy as a whole are highly indebted, their deleveraging will mean decrease of productivity in the economy as a whole.
This is my explanation for the existance of business cycles. The main reason for me is the risk of default which exists always, when the entrepreneur takes the obligation to pay something, which he doesn’t currently own, the classical example being debt. If the risk of default of a business is 0,1% per month, over 10 years it is ~11% and over 50 years it is ~45%. This means that sooner or later the business will go bankrupt. And banks which lend borrowed money are an example of such businesses. Leverage means higher profits at higher risk, while deleveraging means lower profits. So in a period of leveraging a single business or the economy as a whole will be producing more and having higher profits, while in a period of deleveraging the production and profits will decrease.
Now let’s look at the theory of business cycles as explained by the author:
“In periods of sustainable economic growth, higher productivity or increased rates of saving mean a real increase in the ongoing stream of resources available for capital investment. Such an increase makes it possible to fund more ambitious capital projects. The market signal for this flow of real savings is a decline in the rate of interest. But with its overweening power, the Federal Reserve can also lower the rate of interest through artificial bursts of credit expansion; but it can only do so temporarily, or else its monetary expansion will lead to hyperinflation and the complete breakdown of the money economy.”
The basic premise of the Austrian theory of the business cycle is that the market participants are starting projects by borrowing at a low interest rate and being totally surprised and wiped out by an increase of the interest rate. This means that they borrowed for too short period and didn’t take into consideration a possible increase in interest rates. This seems to be the case with Craig, who negotiates new loan each week in the example. And for me this means that such investors were not skilled or experienced enough, just like Craig, and probably would have went out of business for some other reason. And it really was not the case with giant companies like Fannie Mae, Freddie Mac, Lehmann Brothers, Bear Stearns, AIG etc. In fact the interest rates in USA didn’t rise, but still many businesses went bankrupt. How was that possible? According to Mises and Lilburne, the bust of the cycle comes when interest rates rise. This didn’t happen in the US. So why did the businesses go bust?
I claim that it’s because of their leverage. Here is a graph with the leverage ratios for major investment banks from 2003 to 2007:
http://upload.wikimedia.org/wikipedia/en/9/9f/Leverage_Ratios.png
Fannie Mae and Freddie Mac were exempted from the minimum 3% leverage requirement, so they were even highly leveraged. Their collapse was inevitable.
Individuals and companies were also highly leveraged. Here is a graph of commercial and industrial loans at all commercial banks (notice the drop in the beginning of the 90′s, beginning of the new century, in 2008…) :
http://research.stlouisfed.org/fred2/graph/?s1id=BUSLOANS
After 1929 there was massive deleveraging going as well.
In some way the Austrian theory involves the idea of leveraging and deleveraging during booms and busts. But it sees the reason for them in the change of interest rates. According to it, higher borrowing is only a consequence of low interest rates. On the other hand, the empirical evidence is that busts occur also in periods when there is no increase of interest rates, which was the situation in our current crisis. So for me the main reason for a bankruptcy of a business is the debt. When many big businesses in an economy are higly leveraged, this should bring a crisis sooner or later. The US interest rates haven’t increased in the last years, so this means that no bust has happened yet, at least from the point of view of the Austrian business cycle theory.

Old Mexican January 15, 2010 at 5:25 pm

Re: Billwald,

People who have tens of millions increase in personal assets every year are working for power and control, not for spending money.

Unless these people confessed this to you, or you can read minds, then you would be doing nothing more than guessing as to their motives. In economics, motives are totally irrelevant – who cares why they want to make money? What matters is that they are doing it honestly.

They will not work any less because of any tax laws.

Again, you’re just guessing as to what people will decide to do.

I propose a 100% marginal income tax rate set at 1000 times the federal minimum wage. Someone please explain how this will destroy the American economy.

It would make any industry dependant on economy of scale unprofitable, since 1000 times the current federal minimum wage is something like $16.5 million dollars per year. Many medium size companies have revenues much higher than that.

Inquisitor January 15, 2010 at 11:04 pm

Probably too many errors in there to begin with but…

“- We have empirical evidence from the futures and options markets that market participants are paying higher prices for later rather than sooner consumption. This fact contradicts the theory of time preference.”

Homogeneous goods or not? The fact that they’re “physically” identical does not mean they’re subjectively ascertained as such. Down the toilet goes the “empirical” evidence. It ain’t a “theory”, darling, it’s a fact about the world. Perhaps you should read more on Austrian theory to get a sound understanding of it. And no, the ABCT does not presume to explain every single business cycle… only those to do with lowering interest rates arbitrarily.

“On the other hand, the empirical evidence is that busts occur also in periods when there is no increase of interest rates, which was the situation in our current crisis.”

Who says it requires a higher official rate…?

Inquisitor January 15, 2010 at 11:06 pm

” I propose a 100% marginal income tax rate set at 1000 times the federal minimum wage. Someone please explain how this will destroy the American economy.”

Well, let’s feed everyone vitriol. Tell me how this will destroy the human organism. Clearly it won’t, I the socialist imbecile know better. Billwald, full of rubbish, as usual. I can’t believe you fail to apprehend what that would do. Naivety? Dumbness? Trolling?

Nikola January 16, 2010 at 3:14 am

“Probably too many errors in there to begin with but…”

I will be glad if you point some errors, but in your first posting you didn’t mention any.

“Homogeneous goods or not? The fact that they’re “physically” identical does not mean they’re subjectively ascertained as such. Down the toilet goes the “empirical” evidence.”

Well, if future gold is more expensive than present gold because it is “subjectively ascertained” to be different, then why does the author accept that future marshmallows are cheaper than present marshmallows because of time preference? Aren’t they “subjectivelt ascertained” to be different? The theory of time preference holds true in his theoretical example of present and future marshmallows, but doesn’t hold true in real life contracts for present and future gold. Why is that? And by the way, gold is just one commodity which is more expensive the farther in the future you want to have it, but this is true for all other commodities. I’m pretty sure that if people start trading marshmallows, their future price will also be higher than their present price.

“And no, the ABCT does not presume to explain every single business cycle… only those to do with lowering interest rates arbitrarily.

“On the other hand, the empirical evidence is that busts occur also in periods when there is no increase of interest rates, which was the situation in our current crisis.”

Who says it requires a higher official rate…? “

So do you think that the current crisis was caused by higher real interest rates or not? I don’t understand from your posting.

Kerem Tibuk January 16, 2010 at 4:24 am

This is not completely relevant to interest and capital structure but there is a mistake in Austrian theory of money that is repeated in the article.

“As Mises wrote, money is an economic good.”

Money is not a “good”. Money is a function just like good is a function.

“Good function” is a function about satisfying direct or indirect human wants. Or rather, if a commodity satisfies human wants directly or indirectly we call it a good. That is why the more goods you have the wealthier you are.

“Money function”, also can be called “liquidity function”, is a medium of exchange function. It doesn’t satisfy human wants directly or indirectly but facilitates exchange. That is why total supply of money is irrelevant. That is why money doesn’t equate wealth. The only requirement regarding supply of money is its stability because stable supply guarantees stable purchasing power, which is essential regarding “money function”.

And they work inversely, meaning if some commodity with a “good” function starts to gain “money” function it will lose its “good” function. That is why some people think gold is useless. They are thinking about “good” function when they are talking about being useless but clearly gold has money function that makes it useful in another sense, or function.

Why does this matter?

It matters because identifying money as a function stops you from making mistakes like trying to measure supply of money. Money is a function inherent in some commodities but it is not related to their physical attributes like the numbers on them or their weight.

Even if there was only gold being used as money you couldnt measure its supply by weighing the total gold. Because gold still has good functions inherent in it. Since both functions also depends on subjective valuations of millions of people, you can never know, which holders of gold view it as money and which view it a good (like jewelry or electronics parts).

Also when money substitute and derivatives come into the picture things get more complicated, hence the great inflation-deflation debate even among Austrian who have the best understanding of money.

Nikola January 16, 2010 at 7:12 am

Hello mr. Tibuk.

Your posting is relevant to the Austrian business cycle theory, because Mises and Lilburne assume that expansion of money supply causes lower interest rates. Mises and the Austrian economists in general also assume that lending by fractional-reserve banks expands the money supply, and this is not correct. I would have commented this in my first posting, but it would have become too long.

Whether money is “good” or a “function” and whether good is a function seems like a matter of definition to me. I agree with Mises’ definition of money – medium of exchange. This is from “Human action”:

A medium of exchange which is commonly used as such is called money. The notion of money is vague, as its definition refers to the vague term “commonly used.” There are borderline cases in which it cannot be decided whether a medium of exchange is or is not “commonly” used and should be called money. But this vagueness in the denotation of money in no way affects the exactitude and precision required by praxeological theory. For all that is to be predicated of money is valid for every medium of exchange.

So not only gold, but every other good might be used as a medium of exchange and as something else. Therefore using your terminology every medium of exchange will have “liquidity function” and “good function”. The money supply of dollars is easy to be determined, because people use them almost only as a medium of exchange. So it’s not that complicated, but I don’t agree with Mises’ and Rothbard’s views about the money supply. They think that deposits are part of it. Deposits are included in the Austrian Money Supply and demand deposits are considered to be money in every other money supply measure that I know. So I would like to comment on these ideas:

1. Does lending by fractional-reserve banks expand the money supply?

The answer for me is clear – no, and this was the main view until the 20th century. When Mises and Irving Fisher wrote that it expands the money supply, their ideas were quite new and extraordinary. Now they are universally accepted. The basic reason for Austrians to claim that bank lending expands the money supply was that people think of their deposits as of money. So when calculating the money supply, they view deposits as equal to cash. But there is one obvious proof that they are not equal – if all the cash in the economy disappears, the deposits will be worthless, because the banks will be unable to repay them, so the money supply will be zero. And if all the deposits in the economy disappear, the cash will still be there, so the money supply will be equal to the cash. Therefore deposits are not equal to cash. The main mistake of the Austrians here is that they assume that people don’t make a difference between cash and deposits, because they can write checks on deposits. So Mises thought that people consider a check as having equal value as a gold coin. I really doubt this. And bank runs prove that people don’t consider deposits as equal to cash. Before 1933 people were changing their banknotes for gold and this led the US government to prohibit ownership of gold. So back then people were not considering banknotes as equal to gold.

I think that people always made a difference between cash and a promise for future payment of cash. And actually not only banks are able to promise future cash payments – everybody can borrow money and promise to pay interest on them. Nowadays exist huge institutions which are not banks but do this. This is described by the term “shadow banking system”. So if lending by fractional-reserve banks expands the money supply, what happens when non-banks lend? What happens when an investment bank borrows money from investors and invests in high-yield corporate bonds or mortgage-backed securities? The result is the same as when a commercial bank borrows money from depositors and invests in lending. In both cases we have a leveraged insitution, but in none of the cases the money supply has increased.

2. Does expansion of money supply cause lower interest rates?

As I already showed, borrowing and lending, either by banks or by non-banks, doesn’t expand the money supply. So the fractional-reserve banking doesn’t expand the money supply and doesn’t lower interest rates, although Mises assumes the opposite in his business cycle theory.

But maybe if money supply is expanded by simple helicopter dropping this will lower interest rates? The answer is no and Lilburne knows this. If new money is dropped randomly or is given in equal amounts to everybody, this will create inflation, but will not lower interest rates. So Lilburne assumes that Helicopter Ben “dumps hundreds of plaster-of-Paris, fake seashells at regular intervals into the storage pits of all the lenders on the island, including Carolyn. Helicopter Ben insists that dumping new money onto the credit market (“credit expansion”) will help the economy to grow..

Here the problem is that Ben gives seashells only to the “lenders on the island”. The island lenders are not borrowers. And in the real world fractional-reserve banks are in the same time lenders and borrowers. So when in the real world the central bank is giving money to fractional-reserve banks, these money are not given only to lenders, but also to borrowers. If they were not given, the banks would have gone bankrupt, because they are borrowers too. The depositors are lenders to the banks, so if the central bank gives money to all lenders, they should give the same proportion of money also to the depositors. And the end effect will be no decrease of interest rates. When in the real wolrd central banks give money to banks, but not to depositors, they are not “dropping new money onto the credit market”, but are dropping new money onto their friends, relatives and business partners.

So expansion of money supply will not cause lower interest rates, but dropping new money onto friends, relatives and business partners will.

Therefore I don’t agree with the Austrian theory of the business cycle, because it assumes that fractional-reserve lending by banks increases the money supply, this leads to lower interest rates and this causes entrepreneurs to invest unsuccesfully.

Gene Berman January 16, 2010 at 8:42 am

Nikola:

Inquisitor has tried to explain matters but has chosen to deal with your errors in a “backwards” fashion, dealing with some misinterpretations, rather than the root.

The additional sum added to a loan or deferred-payment contract has no role in the explanation of interest or “time preference”; indeed, it cannot be understood properly except in light of fundamental theory–and that theory is at the heart and forms the very basis of Austrian economics. Indeed, ALL neoclassical economists (including both the mainstream and the Austrians) recognize this basis, though all except the Austrians pay mere lip service (and it would be well to account for the fact, also, that the “classical” economists, today represented only by the Marxians, have no explanation for the phenomenon other than “selfishness,” “greed,” or “power”).

TP/INT is inseparable from the very definition of human “acting,” which ALWAYS means ordering, prioritizing, and choosing (when these are not involved, we call the processes “autonomous,” as in the cases of circulation of the blood, secretion of glands, etc.–though, in some cases, even these may be subjected, as in the case of breathing or the suppression of a sneeze, to the choice implied by acting–and so may be considered “actions,” OR we term them “reflexive,” which I think I need not explain further).

All acting implies consideration and–no matter how brief–ordering, prioritizing, and choosing. (And, even in doing nothing, when something could have been done, is illustrated a choice at the moment in time.) It is only this gradation or prioritizing which even permits recognition, that, in action (and only in acting) can we understand the origin of “value”–the relative position occupied on our “list.” You could say (and Austrians do say) that, if it were not for TP/INT, there’d never be reason (other than satiation or exhaustion) NOT to consume. From this definitional understanding of what it means “to act” it is obvious–cannot, logically, be otherwise–that the same things available at two different instants in time–must be valued differently; we’ve named this difference “time preference,” which, loan and deferred-payment contracts recognizes as “interest” (though typically adds allowances for risk and for changes in purchasing power of the currency in which denominated–these are not “interest” in an “economic” sense.

Your interest in the matter is entirely commendable, your logic coherent, and the flawed conclusions due entirely to the misapprehensions in premises. You really owe it to yourself to read Mises.

Gil January 16, 2010 at 9:46 am

Lol! A few people didn’t get that billwald was kidding!

Nikola January 16, 2010 at 9:54 am

Mr. Berman,
again it seems to me that what we are disputing is a matter of definition. You say that loan and deferred-payment contracts don’t recognize as interest “allowances for risk and changes in purchasing power of the currency in which denominated“, because “these are not “interest” in an “economic” sense.” So you first define the economic sense of “interest” and from your definition you conclude that loans recognize as interest only “time preference”. In this case I can not argue with you that risk is the main reason for interest, because your own definition for “interest in the economic sense” excludes risk.

In your definition the reason for interest on loans is the time preference, and you define time preference as the fact that “the same things available at two different instants in time must be valued differently“. Ok, but what about the futures markets? How do they fit in your definition? They are exactly markets for valuing the same things at two different instants in time. We see from them that people almost always pay higher prices for later goods. And according to the Austrian view on time preference later goods should be always cheaper. So the theory might be nice, but it contradicts facts from real life. I have my own explanation for this, but I suppose it will be very hard to explain it. I’m curious how people believing in the theory of time preference for sooner goods can explain the futures prices on real world markets.

Inquisitor January 16, 2010 at 11:40 am

Nikola, rather than wasting my and your time, define “good” please. Because you still do not get it. Goods are valued subjectively, so physically “identical” goods will not be seen as such depending on what ends they service. Reading even Menger would tell you this much. And Gene, I don’t care if you dislike my approach or think it to be “backwards”. I don’t waste time on lengthy posts, too many other things to do, so I go for the most glaring errors.

Inquisitor January 16, 2010 at 11:55 am

Forgot this…

“So do you think that the current crisis was caused by higher real interest rates or not? I don’t understand from your posting.”

No. Lower. It does not require the Fed to set a higher rate though, to bring about the bust…

As for interest, the Austrian view is that it originates from Time Preference, NOT that other factors like risk &c. do not go into its market rate. They either increase or decrease it but are not its origin. And a good is ALWAYS something of subjective value and nature to an agent, i.e. it is perceived to service a given end. As ends are serviced ever less urgent wants are serviced. Thus, the good will be ‘security of mind’ rather than ‘gold’ or ‘loans’ simpliciter. Their physical constitution is incidental. The good is defined in subjective terms.

Nikola January 16, 2010 at 12:36 pm

Nikola, rather than wasting my and your time, define “good” please. Because you still do not get it. Goods are valued subjectively, so physically “identical” goods will not be seen as such depending on what ends they service. Reading even Menger would tell you this much.

Ok, I agree with you on that. But what do you prove with this observation? Does it prove that sooner products are more expensive than identical later products, as the theory of time preference says? Does it explain why futures on commodities in the real world are more expensive the farther their expiration date is? I don’t think so.

Fallon January 16, 2010 at 2:17 pm

Nikola,

Why wouldn’t you have to pay more for a longer futures contract? You are paying for a locked-in price in an uncertain reality. The longer the time frame, the more the uncertainty; the more the uncertainty, the higher the price, right?

Nikola January 16, 2010 at 2:41 pm

Yes, Fallon, I totally agree with you. The reality is uncertain, and for me this is the main reason why people pay more for later goods rather than for sooner. And the uncertainty is even more emphasized in the price of options, where time is even more expensive.
The Mises’ theory of time preference assumes a certain world in which future goods will be delivered for sure and debtors will never default. If the result of all economic activities was certain and debtors never defaulted, then it will be logical for later goods to be cheaper than sooner. People will be sure that the later goods will be there, but if they buy them, they will have to wait, so they will be cheaper. A person who borrows money now and will give them back for sure will have to pay interest, because otherwise the lender can invest the money in some other economic activity which will bring him certain profit. The examples from the article with Carolyn and Craig on the island also assume a certain world in which every enterprise of Craig has successful outcome for sure.
But things don’t work this way in the real world, there are no riskless borrowers and no riskless investments, so this is why “the longer the time frame, the more the uncertainty; the more the uncertainty, the higher the price”, as you say.

Fallon January 16, 2010 at 3:19 pm

Nikola,

But isn’t the Carolyn and Craig example just expressions of Misesian even rotation with the ceteris parebus modified to account for time preference? In other words, it is not meant to be empirical. Their case is the logical derivation based on the axioms of human action.

Risk premium would add yet another factor that does have the empirical side- also to be weighed against the subcategory of risk within the logic of human action.

Of course reality gets a lot messier, hence the insistence, no…rather, the necessity of apriori tools by which to understand the complexity.

I am not sure that empirical cases can disprove the logic of human action at all. To undermine Time Preference as the basis for interest wouldn’t you first have to find error in the logic?

Nikola January 16, 2010 at 5:04 pm

Fallon,

“To undermine Time Preference as the basis for interest wouldn’t you first have to find error in the logic?”

First of all, the purpose of the theory of time preference was to explain the existence of interest – a real world phenomenon. But it turns out that its premise (sooner goods are more expensive than later) contradicts real world observations. So this should be enough to dismiss this theory as an explanation for the existence of interest.

But if I have to find error in the logic, I would point this:

From the observation that A.people prefer sooner consumption rather than later is derived the conclusion that B.sooner goods are more expensive than later. But B contradicts reality. Why is that? Because people’s time structure of consumption preferences is not the only factor that affects prices. As we know, prices are subjective, so the factors affecting them are countless. This means that from observing A we can not establish B. Even if in reality sooner goods were actually more expensive than later, this would not confirm the theory. The theory can be true only if we eliminate all other factors which affect prices, like for example risk. Mises did eliminate risk in his reasoning, as can be seen in this quote:

Those contesting the universal validity of time preference fail to explain why a man does not always invest a sum of 100 dollars available today , although these 100 dollars would increase to 104 dollars within a year’s time. It is obvious that this man in consuming this sum today is determined by a judgment of value which values 100 present dollars higher than 104 dollars available a year later. But even in case he chooses to invest these 100 dollars, the meaning is not that he prefers satisfaction in a later period to that of today. It means that he values 100 dollars today less than 104 dollars a year later.
So Mises says that 100 dollars invested for a year would increase to 104 dollars. He assumes riskless investing, just like Lilburne in the article, and this doesn’t exist in reality.

Another fact which we have to dismiss if we derive B from A is that people don’t always consume. In reality many people earn more than they consume, so they want to save part of their earnings for a later period. An example are the pension plans. So these people actually prefer later consumption rather then sooner for a part of their earnings, and their actions contradict A.

As I said, the factors which affect prices are countless, I just point that the theory of TP doesn’t take into consideration risk of investment and saving. It focuses entirely on consumption. I can think of other factors which affect prices, but it’s enough to say that if we accept that prices are subjective, we can not derive B from A. B is a statement about the prices of goods, and A is just one of the possible factors affecting them.

J. Grayson Lilburne January 16, 2010 at 6:06 pm

Nikola,
You are ignoring the ceteris paribum element of the theory. Moreover you seem to be inferring from the fact that Misesian interest theory sees time preference as the fundamental underlying cause of interest the false conclusion that Misesian theory considers no other secondary factors in modulating observable rates. My piece is an article for the edification of the lay person. It is not an academic paper. So I don’t go into all the components which, in addition to originary interest, factor into the gross market rate of interest: the entrepreneurial component, the price premium, etc. But all those factors are included in the full theory, which you can find in chapter 18 of Human Action.

Inquisitor January 16, 2010 at 9:59 pm

Ok, I agree with you on that. But what do you prove with this observation? Does it prove that sooner products are more expensive than identical later products, as the theory of time preference says? Does it explain why futures on commodities in the real world are more expensive the farther their expiration date is? I don’t think so.

Did you actually disprove TP as originary of interst? I don’t think so. WHy? because you’ve STILL not defined a good. It proves you are utterly wrong if your definition is inconsistent with the Austrian one, meaning you’re not even theoretically cognisant of what is being talked about.

Inquisitor January 17, 2010 at 12:13 am

Re-reading this all, wow failure to understand both ceteris paribus and the fact that a good does not merely refer to some physical thing… and spelling errors in my earlier post…

christopher bladon January 17, 2010 at 12:28 am

Nikola wrote: the theory of TP doesn’t take into consideration risk of investment and saving

Nikola, explain why the bartered interest rate under TP could not have risk bundled into it. I get the impression that you don’t really want to learn Austrian thought but nevertheless want to argue against it.

Nikola January 17, 2010 at 3:48 am

I think I wrote enough about what I wanted to say. If anybody understood some of my points, I’m glad. If somebody thinks that I “don’t really want to learn Austrian thought” or that I’m “not even theoretically cognisant of what is being talked about”, that’s ok, I can’t prove them wrong. But still the question why in the real world future commodities are more expensive than present remained unanswered. And this is what Mises wrote:

Satisfaction of a want in the nearer future is, other things being equal, preferred to that in the farther distant future. Present goods are more valuable than future goods.

http://mises.org/humanaction/chap18sec2.asp

This is A and B from my previous posting. A is correct, B is not. We can not derive B from A.

Nikola January 17, 2010 at 3:59 am

And here is Mises writing about “originary interest”:

Originary interest is the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remote periods of the future. It manifests itself in the market economy in the discount of future goods as against present goods. It is a ratio of commodity prices, not a price in itself. There prevails a tendency toward the equalization of this ratio for all commodities. In the imaginary construction of the evenly rotating economy the rate of originary interest is the same for all commodities.

Again the first sentence is A, and the second sentence is B. He derives B from A, which is an error as I showed. And he didn’t take into account the fact that in the market economy there is actually a discount of present goods as against future goods.

Fallon January 17, 2010 at 5:31 am

Nikola,

A futures contract does conform to Misesian time preference. The purchaser buys the right to a particular price in the future where, ceteris paribus (right spelling I believe lol), those that do not hold futures have to wait and see what price evolves. The purchaser desires a solid price now over later and is willing to pay for it.

Nikola January 17, 2010 at 6:28 am

Fallon,
the traders of futures on commodities trade commodities. The two parties in a futures contract are in the same situation like two parties who agree on an immediate settlement, the only difference being that the futures contract will be settled at a certain date in the future. The purchaser desires the commodity later over sooner and pays now to receive the commodity later.
Let’s illustrate it with an example. Alice desires “a solid price”, as you say, and buys a futures on 100 troyounces of gold with a delivery date in December 2014 for $1298.9/troyounce – http://www.cmegroup.com/trading/metals/precious/gold.html

Bob buys 100 troyounces of gold on the spot price for $1130/troyounce. He doesn’t desire “a solid price”, and therefore pays less, according to your argument.

December 2014 comes, they both have 100 troyounces of gold. The spot price of gold in December 2014 might be $500, might be $5000, or might be $1130. Is Alice somehow in a better position than Bob? Does her gold have more solid price? No. Alice’s gold and Bob’s gold have the same price in December 2014. So why did Alice pay more if she didn’t get a more solid price than Bob?

newson January 17, 2010 at 8:03 am

guido hülsmann points out the flaw in mises’ time preference theory, reformulates it, and makes it more robust. a must-read:

http://mises.org/journals/qjae/pdf/qjae5_4_7.pdf

Fallon January 17, 2010 at 8:49 am

Nikola,

Futures no longer deal in commodities only btw.

However, it does look like Alice gambled and lost relative to Bob. But at the time of her purchasing the contract she valued the price 1298.9 over the unknown future spot. This is the key moment. Alice preferrred the now over the later regarding a price. It is irrelevant whether she won or lost on the bet.

What I meant by solid price is the certain price, not the eventual winning price that only time could reveal.

Newson, thanks for the link.

Fallon January 17, 2010 at 10:48 am

Newson,

Hulsmann: “Originary interest is the fundamental
spread between the value of an end and the value of the means that serve to attain this end.”

Well, this certainly puts everything on a different axis.

Fallon January 17, 2010 at 1:03 pm

Nikola,
I should have wrote that is possible for Alice to lose relative to Bob… But even still, Alice may have other investments at the time of her purchasing the futures contract that make it optimal for her to not spend the whole $1130/troy at the same time Bob did. Bob does hold the gold 4 years. I guess the picture has to be made larger. Are we assuming that Alice could have bought the $1130/troy at the same time as Bob?

Maybe she didn’t have the money at the time anyway?

Nikola January 17, 2010 at 4:34 pm

Fallon,
if we don’t take into account storage costs, risk of theft or loss etc., Alice loses in any case relative to Bob, because she simply pays more. If we take them into account, then this is probably why she pays higher price for the future commodities.
She doesn’t get a secure price, because prices of futures on gold fluctuate just like the spot price. So she doesn’t pay higher because of a secure price.

Gene Berman January 19, 2010 at 8:37 am

Inquisitor:

My use of “backwards,” was, perhaps, unfortunate, simply because the word is often used in a pejorative sense, whereas I had used it quite literally.

There’s no use in any arguments raised against Nikola’s criticisms–they’ll fall short, it seems, of persuading him to actually read MIses in any other than “sound bite” fashion (fueled by desire to find
statements or passages to which some objection, on whatever basis, may be raised). I wouldn’t say he’s a “lost cause”–he does seem incisive, insightful, and logical–simply one I can’t spare time to attend other than to make the recommendation I did. (And that, generally, is a serious shortcoming in a forum such as is this one, though I’ve not got anything better which could replace it. I do what I can to persuade those I perceive as serious critics to actually read (in more than “sound bite” fashion)
Mises but have no rosy appraisal of the result of such effort.

The “backwards” remark had to do with trying to correct Nikola’s criticism of a particular conclusion with remarks centered on that conclusion (rather than pointing out the underlying premise–and, perhaps, the irrefutable logicical train leading to the correct, Misesian, conclusion). I don’t insist that
an argument directed in the fashion I suggest will always (or even very frequently) persuade an opponent (or the audience) of its correctness–merely that one centered on conclusions will nearly always be unsuccessful (and especially likely to degrade into questions and disputes involving semantics, etc.).

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