Mises Daily Articles
The Pure Time-Preference Theory of Interest
Consumers and entrepreneurs often speak of "the cost of money" when referring to interest rates. Modern lenders also refer to the interest they charge as "loan pricing." Viewed this way, interest is viewed as if it were any other good. The cheaper a good the more affordable it is. And so the lower the interest rate, the more affordable. By dictating key interest rates, modern central bankers are believed to be alchemists, lowering interest rates to magically transform scarcity into prosperity.
As the world struggles to deleverage, with the market constantly forced to clear malinvestments of a continuous string of asset bubbles and crashes, central bankers continue their faith in the ancient tradition. All the economy needs is more monetary elixir. If the patient hasn't yet responded, it must mean larger doses are needed: Interest rates must be too high.
The mainstream view has devolved to the belief that zero is too high. In the spring of 2009, Harvard economist, and former adviser to President George W. Bush, N. Gregory Mankiw seriously wrote in the New York Times, "It May Be Time for the Fed to Go Negative." But who would lend money to only receive less in return?
Mankiw approvingly cites German economist Silvio Gesell's argument for a tax on holding money, an idea John Maynard Keynes himself approved of. Crazier still is Mankiw's idea that one of his graduate students floated, of turning interest-rate policy into an absurd game of chance.
Imagine that the Fed were to announce that, a year from today, it would pick a digit from zero to 9 out of a hat. All currency with a serial number ending in that digit would no longer be legal tender. Suddenly, the expected return to holding currency would become negative 10 percent.
That move would free the Fed to cut interest rates below zero. People would be delighted to lend money at negative 3 percent, since losing 3 percent is better than losing 10.
Of course, some people might decide that at those rates, they would rather spend the money — for example, by buying a new car. But because expanding aggregate demand is precisely the goal of the interest rate cut, such an incentive isn't a flaw — it's a benefit.1
Mankiw recognizes that the idea of negative interest rates is nonsense to most people. But he writes, "Early mathematicians thought that the idea of negative numbers was absurd. Today, these numbers are commonplace."
However there is nothing new about the idea of the state juicing up an economy with low interest rates. John Law's monetary theory for an ailing France in the early 1700s was built on a foundation of low interest rates. The Scottish economist and policy maker believed interest rates were derived from
(1) the quantity of money, (2) the quality of the government, and (3) the security of the state's debt. If the quantity of money increased relative to the demand for it, the government of the country was good, and the state debt secure, then, interest rates would fall.2
The result of Law's monetary experiment was the famous Mississippi Bubble that devastated the French economy. The continuous injections of new money that Law flooded into the market not only rushed into Mississippi Company shares, but into commodities as well, while money wages for the French working class never caught up.
And so it goes today.
However, Keynesians are undeterred in their belief that low interest rates put people back to work and solve all economic woes, albeit with nagging liquidity-trap apprehension. Keynes believed the rate of interest is "the reward for parting with liquidity for a specific period … is a measure of the unwillingness of those who possess money to part with their liquid control over it."3
Keynes believed that those who hold cash for the speculative motive to be wicked. And it is up to central bankers to stop this evil. However, Henry Hazlitt explained in The Failure of the "New Economics," holding cash balances
is usually most indulged in after a boom has cracked. The best way to prevent it is not to have a Monetary Authority so manipulate things as to force the purchase of investments or of goods, but to prevent an inflationary boom in the first place.4
Keynes thought money to be barren as a store of wealth while investments yielded returns, writing "Why should anyone outside a lunatic asylum wish to use money as a store of wealth?"
If liquidity preference determined the rate of interest, rates would be lowest during a recovery and at the peak of booms, with confidence high, everyone would be seeking to trade their liquidity for investments in things. "But it is precisely in a recovery and at the peak of a boom that short-term interest rates are highest," Hazlitt writes.
Time is what Keynesians leave out of their calculus. While lenders may think they are lending money, they are really lending time. Present goods are more valuable than future goods. Borrowers buy the use of time. Hazlitt reminds us that the old word for interest was usury, "etymologically more descriptive than its modern substitute."
Borrowers pay interest in order to buy present assets. It is time preference that determines interest: the discount of future goods as against present goods. Most importantly, this ratio is outside the reach of the monetary authorities. It is determined subjectively by the actions of millions of market participants.
Central bank manipulation of interest rates can never fix an ailing economy. It is impossible for the monetary authorities to dictate the proper interest rate. Interest rates determined by command and control bear no relation to the collective time preference of economic actors. The result of central bank intervention can only be distortions and chaos.
Those pushing the monetary buttons are naïve in believing they can steer the economy by setting interest policy when, in fact, they don't understand what interest is or how the rate of interest is determined.
The following essays parse through the uniquely Austrian insight of the pure time-preference theory of interest, but more importantly go to the core of why modern central bank monetary engineering leaves the economy further from recovery while at the same time providing a Petri dish for speculation and malinvestment.
- 1. N. Gregory Mankiw, "It May Be Time for the Fed to Go Negative," New York Times, April 18, 2009.
- 2. Antoin E. Murphy, John Law: Economic Theorist and Policymaker (Oxford: Oxford University Press, 1997), p. 65.
- 3. John Maynard Keynes, The General Theory of Employment, Interest and Money (New York: Harcourt, Brace and Company, 1936), p. 167.
- 4. Henry Hazlitt, The Failure of the "New Economics" (Princeton, N.J.: D. Van Nostrand,1959), p. 190.