The Pure Time Preference Theory of Interest and Its Enemies

0:00I just want to focus on one thing, one main issue from this paper. As you can imagine from the title, it's rather expansive, and this is the issue that was posed by Boehm-Bawerk. Murray writes in Positive Theory. The difficulty is, and indeed I think it is at once the greatest and most stimulating difficulty of the whole problem of interest. The difficulty is to explain in what manner and by the employment of what intermediary processes, those heterogeneous component elements, they include objective technical factors and highly subjective psychological motives, combine and cooperate to produce that end result, which we know as the homogeneous phenomena of interest.

0:48That truly is a key question in interest rate theory and what I will argue here is that the pure time preference theorists were the ones, this is the line of thought in interest theory that is consistent with Menger's causal realist framework of economics. And that's what I hope to demonstrate for you here quickly today. Menger's conception, if I might state it briefly, from the Marginalist Revolution as opposed to Jevons and Varra, was that in human action the human mind integrates all of the different factors that are relevant for action.

1:41It's the human mind that is the organizing phenomena of human action, and therefore it's the judgment of the human mind that is the determining factor in every element of human action. There are, of course, objective factors in human action, but their influence to the actor depends upon the judgment of the actor's mind. Now, if we look at this, if we look at a sketch of the pure time preference theory of interest with respect to this conception, it might look something like this, and at the top I just have a kind of Mengerian system of cause and causal chain, as we move from preferences that people have in their minds, to demands that people have in their minds.

2:33to demand and supply in markets for goods, which then determine the prices of goods. So we have this classic Austrian argument that it's preferences or subjective value that determine prices. And as we know, the causal chain continues from the prices of goods to the marginal revenue product to the factors of production. I point this out, again, in interest theory, because there are a lot of interest theories that claim that productivity has an independent effect on interest. But in the McGarrion conception, this is not correct. It has no, in fact, direct causal effect on interest at all. The productivity factors, both physical and value productivity, as Boehm-Bawerk put it, enter into the prices of the factors of production and then through rental prices of these factors of production into the capital value of assets.

3:30And you'll notice that the capital value of assets is determined by the sum of the rental prices discounted by the rate of interest. This was a key point made by Frank Feder that we'll talk about in a minute. So the argument then is that time preferences have the same causal link to the interest and the interest rate as a price, as preferences generally have through demand and supply to the prices of goods. So that is a quick schematic of this. Now, I want to end, I'll elaborate in a moment on some of these points, but I want to say that this theory was actually brought forth by the great American economist, and economist, Frank Fetter, in a book that he published, Principles of Economics in 1904, and you might note the date, 1904 is eight years before the publication of Theory of Money and Credit, where Mises integrates money and the theory of money into Menger's system.

4:34This is a very early work and it's a very brilliant work, and one that I would argue who still stands up against all of the criticisms against this theory. Here is Joseph Dorfman, the great historian of thought of American economists on Fedder, where you can see his statement here, his assessment of Fedder's argument of this theory of interest. Since the impulse to seek immediate gratification was rooted in men's nature, in Feder's theory, the gratification of wants at a future date was not as important as present gratification. Thus he found time value pervading the entire economic structure and the capitalization of psychic income, a basic process of human nature.

5:24The capital value of any permanent good, therefore, was the sum of the whole series of rents or incomes it contained discounted at some rate to its present worth. Dorfman here is quite correct in saying, and this will become key in thinking about the criticism of this theory, What Federer argued was that time preference is the preference that a person has for a given satisfaction sooner as opposed to the same satisfaction later. This is a necessary beginning point in the Mengerian conception. You have to start with preferences. You have to begin with the first primary causal factor that sets in motion everything else.

6:12and again for Menger this is the human mind. Now I think that Dorfman makes an error here, and again we'll talk about this in a minute, when he says that this is the summation or the capitalization of psychic income, Actually, as we'll show in a few slides coming, Menger has a very robust and correct view of how capitalization works. So he's not claiming that you can capitalize subjective value. He doesn't actually say that. Although he does have an overly psychological conception of value.

6:58Okay, so Feder says this about time value. Remember in Dorfman's quote he mentions this concept of time value. Feder says this about time value. He says, Time value is the difference between the values of things at different times. The simplest and clearest case of time value is the difference noticeable in the same thing at different moments. Is this good worth more now or next week? Shall this apple be eaten now or next winter? Center. These questions can be answered only after comparing the marginal utilities which differ according to the varying conditions of the two periods. So this is a key point of debate. I know it seems a little off topic, but it's a key point of debate in interest theory, especially the time preference theory of interest. What Feder is saying here is that if we have a good, any particular good that a person might be valuing, not only can Even if its marginal utility differ in different uses in the present, its marginal utility

7:57could differ for different uses at different points in time. And therefore, obviously, there isn't any universal law in motion that would always ensure a premium on the present use of the thing, right? It could be that something is worth more to someone at some later date. Because, as Feder puts it, there are varying conditions, right? Different conditions under which the thing will be used would make it more valuable in the future as opposed to the present. The reason this is relevant is because, again, we'll see in a minute, time preference and interest cannot be conceived of from the pure time preference theory as the trade of present Goods for Future Goods, because, well, time preference won't necessarily be expressed in that kind of a trade.

8:54Okay, so Feder goes on and he says time value then has two different aspects to it. The one that he's talking about in this quote, which is just this different marginal utility for use of a good at different moments in time, that we might call, just for clarity, We might call that the timing of an action, at what time do I take an action, it could have different value whether I take the action in the present or in the future. And then Feder says there's a second aspect to time value and the second aspect is what he calls time discount. And time discount is precisely this idea of what in the literature later came to be called time preference. This is just the premium on a given satisfaction when it's arrived at sooner as opposed to later or again the discount would be, there's a discount on its later use as opposed to its sooner use.

9:54So this is what Feder says about time discount. All the other cases of time value, so he's talking now about the second aspect, can, by the practical device of substituting the other goods of equivalent value, be reduced to the typical case of comparison of the same thing at different times. So Fedders is saying, look, only if we can have an equivalent value in the present relative to the future would we be able to see the time discount. So this is his claim. And we can't do this for goods because we know that it's inherent that the possibility that goods could have greater value in the future. So how is this to be done? And Feder says, well, we can get value equivalents simply by using money in this trade. And he says this, but two or more quite different things may be expressed in terms of another thing and so be made comparable. Money becomes the value unit through which different things may be reduced to the same terms for comparison. With this mode of expressing the value equivalents

10:53of various goods, the interest contract first becomes possible. The comparison of the value The theory of a bushel of apples with that of a barrel of potatoes or a suit of clothes at the same moment appears simple enough. When all are expressed in terms of money, the comparison of each with its value equivalent at a later date becomes easy. So what Feder is saying here is really just an extension of what Mises would point out in economic calculation, his economic calculation argument later. Money and monetary exchange provides us a common unit of valuing things that we can use to make comparisons of the value of things, both in the present, different things in the present, and Federer is extending that saying the same thing could be true for different things, the monetary value of different things in the future.

11:42So here we have the factor that allows us to isolate the time discount. And Feder then actually says that he uses this language of the pure time preference, he says in these cases where there's a mix of the time and the timing, the timing and the time discount. He says there's no element of pure time preference, no degree of preference for the present unit simply because it is present. So if we were to amend then slightly the time preference cause and effect chain, it would look like this. What Fedder is calling pure time preference is expressed in demand and supply for present money, not goods, and that then gives us the pure rate of interest as a result. It isolates this time preference element.

12:32Now, real quickly, let me just mention two alternative theories. The eclectic theories, notice, already criticized by Boehm-Bawerk, argue that there are two independent lines that affect the interest rate, right, productivity from one side and time preference from the other. One of the founders of this view was John Ray, who is actually Boehm-Bawerk's inspiration, and also the inspiration for Irving Fisher and the neoclassical view. Boehm-Bawerk's view is slightly more sophisticated but no better in terms of the pure time preference theory. Boehm-Bawerk says something like this, we've got what he might call value productivity of capital from the increased roundaboutness that can be engaged in with present goods as opposed to future that affect time preference and then there are the subjective factors, which is three causes, right, the two subjective factors and the roundaboutness that affect time preference, which he defines as the exchange of present goods for future goods and that then they affect the interest rate.

13:42Feder, by the way, criticized Boehm-Bawerk for this, pointing out that in order to calculate the value of productivity, you have to already know the interest rate. So, as he called it, as he pointed out, this suffers from the vicious circle, right, this is circular reasoning. Now, I don't have like a, oh okay, I do have a couple minutes. Let me go on then and just mention some modern criticisms. Bob Murphy in his dissertation makes a couple of criticisms of the pure time preference theory. He argues, and again my basic claim here since I don't have time to go through the thing in detail, But my basic claim is that this criticism is not making this proper Fed or distinction between the trade of present good for future goods, which doesn't isolate the interest rate, and the exchange of present money for future money, which does.

14:37So Murphy says, well there's a dilemma from these two different definitions of time preference. Sometimes time preference is defined in the satisfaction way, like Fed or Mises. Sometimes it's defined in terms of present goods, and obviously if it's a term, what he says is that if it's defined by present satisfactions, then it has no connection with the trade of goods, and therefore the interest rate. And if it's defined as goods, well then it might be a premium of the present or it might be a premium of the future. And again, Federer bypasses this completely by pointing out that it's the trade of present money for future money. That's the way the interest rate is expressed and not the trade of present goods for future goods. And then he says, time preference as a satisfaction is neither necessary nor sufficient for a positive premium of the present.

15:23This is true if you're arguing that the expression of time preference has to be through the exchange of present goods for future goods. That's true. But it isn't true for money. And so, again, this just misses the mark, this argument does. And do I have a minute left to do? Okay, and this is Guido Holzman in the paper he wrote recently criticizing the pure time preference theory. And again, I just take this as kind of his main criticism. But it's based upon the same lack of distinction between exchanging present goods for future goods and exchanging present money for future money that Federer actually cleared up decades ago. So Holzman says there are two contradictory claims that are made by Mises in his arguments And Mises says this according to Holtzman because if this is true then only because of time preference would people desire the present, right?

16:25Otherwise they would always choose the future. But then Mises goes on to say that look, a present good and a future good are not the same thing at all. They're not the same good. Ice in the winter and ice in the summer. and again it's true that Mises makes both these claims but again the pure time preference theory doesn't have anything to do with this because it doesn't argue about present goods versus future goods, it argues only about present money in exchange for future money. The same kind of criticism can be levied at Hultzman's final point where he says that Mises claims that time preference is between two options of choice for the same good so we take a good in the present and compare it to what value we get for the same good in the future and he says well if we do that then we could get a greater value in the future right in the present and we wouldn't have interest from this and again that's

17:12perfectly true that could in fact be the case but as I've argued here Federer's view I think is the correct one where he says no if we want to isolate the time discount we do this by the trade of money present money for future money and and therefore we bypass this whole difficulty. Now some of these criticisms have arisen because of semantic confusion, granted, sometimes the pure time preference theorists have used these terms, present goods, trading for future goods, and it has created some confusion on this point, but I think conceptually the pure time preference theory as given by Federer is immune from these criticisms, so thank you very much.

17:59Thank you very much.