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Hey Rocky, Watch Me Prove Positive Interest Rates Without Time Preference!

March 11, 2005

OK, so it's not Rocky and Bullwinkle. But it seems like it.

Bryan Caplan claims to have demonstrated that time preference is superfluous to the explanation of positive interest rates, since marginal utility all by itself explains positive interest rates. He says: "If you are stuck on an island with two bananas for two days, a perfectly patient person would still want to eat one banana per day. Even though he disvalues hunger today and hunger tomorrow equally, eating one banana today assuages his hunger more effectively than saving that banana for tomorrow." This explains nothing about interest rates.

Caplan says, "You don't need time preference to get people to divide their consumption between today and tomorrow," but that's not what's at issue. It is obvious that people so divide their consumption. It is obvious that an individual, faced with the prospect of earning a rate of interest, might loan his money at interest. The question is, why does such a social state of affairs manifest itself? Why do capitalists, after accounting for entrepreneurial profit, risk, depreciation, and payments to landowners and laborers, earn a surplus?

Boehm-Bawerk, who thought about this issue at length, was well aware of the law of decreasing marginal utility. But, he also realized it did not explain the phenomenon of interest. Instead, he concluded in Capital and Interest: "I may just mention the element which seems to me to involve the whole truth. It is the influence of Time on human valuation of goods." Mises critiqued and improved Boehm-Bawerk, arguing that time preference is a category of action, not a contingent psychological fact. All of this comes full circle to Caplan's main point.

One of the claims of his article is that interest rates are always positive. Since he regards interest rates as being determined by contingent preferences, this is contradictory. The only way to escape this is to claim that preferences are always constrained such that interest rates are positive; but, that's the very concept of time preference which he wishes to jettison!

Note: the link above to Mises's critique of Boehm-Bawerk is preceded by an editorial comment by Bettina Bien Greaves and Percy Greaves, Jr. In it, they attribute the element of uncertainty to Mises's construction of the category of time preference, which I think is incorrect.

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