As a reaction to the global financial and economic crisis, central banks around the world have cut their interest rates to the point of disappearing, because they see low interest rates as being conducive to making economies return to growth and prosperity.
According to the Austrian School of economics, however, the latest crisis has been brought about by a monetary policy of artificially suppressing the interest rate; and pushing interest rates down even further will only make matters worse.
To Austrian economists, a monetary policy of keeping the interest rate at an artificially low level causes malinvestment and prevents the market from correcting misguided production that has been provoked by the monetary policy of suppressing interest rates in the first place.
The conclusion — which stands in sharp contrast to the mainstream economic gospel — rests on the Austrian School of economics’ sound analysis of the nature of and the relations between time preference, the interest rate, and the boom-and-bust cycle.
Time Preference as a Category of Human Action
“Time value is the difference between the values of things at different times,”[1] as Frank A. Fetter (1863–1949) noted, and it arises from time preference, which is, according to Ludwig von Mises (1881–1973), the fact that “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.”[2]
In economics, the elaboration of the theory of time preference is attributable to the work of Eugen von Böhm-Bawerk (1851–1914), who wrote, “As a rule present goods have a higher subjective value than future goods of like kind and number. And since the resultant of subjective valuations determines objective exchange value, present goods, as a rule, have a higher exchange value and price than future goods of like kind and number.”[3]
Mises later showed that time preference is by no means an arbitrary concept. In fact, he pointed out that time preference is a category of human action, derived from the irrefutably true axiom of human action. Mises explains,
No mode of action can be thought of in which satisfaction within a nearer period of the future is not — other things being equal — preferred to that in a later period. The very act of gratifying a desire implies that gratification at the present instant is preferred to that at a later instant. He who consumes a nonperishable good instead of postponing consumption for an indefinite later moment thereby reveals a higher valuation of present satisfaction as compared with later satisfaction. If he were not to prefer satisfaction in a nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the morrow would confront him with the same alternative. Time preference is a category of human action.[4]
Factors Determining Time Preference
Time preference is determined by a number of factors,[5] and these affect the valuation of goods and services, which, in turn, is governed by the apodictically true law of diminishing marginal utility.
To put it simply, the law of diminishing marginal utility says that the larger the supply of a good is, the smaller is its marginal utility; likewise, the smaller the supply of a good is, the higher is its marginal utility.
So, for instance, the higher someone’s income is, the lower is his time preference. This follows from the truism that the larger the supply of a good is, the more of the less urgent needs can be satisfied. So the more goods are available, the smaller is the utility derived from an additional unit of a good.
What is more, private-property violations, in the form of, say, the government imposing taxes, reduce the taxpayers’s income. And the fewer goods remain, the more valuable they become to the taxpayer — and the higher his time preference will be.
Finally, it should be noted that individuals’ time preference is not constant but changes over time and as conditions of life change. For instance, a child typically has a relatively high time preference, while an adult who raises a family tends to exhibit a relatively low time preference.
Time Preference and the Pure Interest Rate
The relation between the value of goods available in the present (present goods) and the value of goods available in the future (future goods) is expressive of the pure interest rate (or, as Mises put it, the originary interest rate).
Here is an example: if people value a US dollar available in one year’s time at 0.9524 US dollar available today, the pure interest rate is about 5 percent per annum ([1/0.9524] − 1).
The higher peoples’ time preference is, the more valuable they consider a present good relative to a future good — and, as a result, the higher is the pure interest rate. Likewise, the less valuable a US dollar available today is relative to a US dollar available in the future, the lower will be peoples’ time preference — and the lower will be the pure interest rate.
Rothbard noted, “This pure rate of interest, then, is determined solely by the time preferences of the individuals in the society, and by no other factor.”[6] It is the result of individuals valuing present goods relative to future goods.
It should be noted that the pure rate of interest differs from the market rate of interest: the market rate also includes an entrepreneurial component and a premium compensating for expected changes in the purchasing power of money.
The Interest Rate and Savings and Investment
How do savings and investments relate to the market interest rate? In mainstream economics it is typically stated that the higher (or lower) the interest rate is, the more (or less) people will save. Likewise, the higher (or lower) the interest rate is, the smaller (or greater) will be investment.
This interpretation basically says that it is the interest rate that determines savings and investment. And so the policy conclusion is that the higher the interest rate is, the higher will be savings and the smaller will be investment. And because investment — rather than savings — is nowadays seen as being conducive for growth, the lowering of the interest rate is perceived as advancing economic prosperity.
Against this backdrop, it may not come as a surprise that in times of an economic crisis a further lowering of the interest rate is seen as being an appropriate recipe for making the economy return to higher production and employment.
From the viewpoint of the Austrian School of economics, however, it is the artificial lowering of the interest rate that causes malinvestment and the ensuing financial and economic “crisis.” And a further reduction of the interest rate makes things worse.
Before discussing these conclusions in some more detail, it may be advisable to explain what the relation is between the interest rate and savings and investment from the viewpoint of Austrian economics.
Savings are indeed positively related to the interest rate: the higher the interest rate, the higher the savings. Investment, in turn, is negatively related to the interest rate: the higher the interest rate, the lower the demand for resources and so the lower the level of investment.
However, it is not the interest rate that determines savings and investment — as suggested by mainstream economics. The interest rate is expressive of peoples’ valuation of present goods relative to future goods. It is, so to speak, a resulting variable rather than a forcing variable.
Mises explained it the following way: “People do not save and accumulate capital because there is interest. Interest is neither the impetus to saving nor the reward or the compensation granted for abstaining from immediate consumption. It is the ratio in the mutual valuation of present goods as against future goods.”[7]
The Boom-Bust Cycle
In today’s fiat-money regime, money is produced through bank circulation credit: when they lend to private households, firms, and public-sector entities, banks increase the money supply (fiduciary media).
Money creation through bank circulation credit is, on the one hand, money creation out of thin air, a rise in the money supply that is not backed by real savings. On the other hand, bank circulation credit wreaks havoc with the essential function of the interest rate.
The rise in bank circulation credit necessarily lowers the market interest rate to below the natural interest rate — that is, the pure interest rate adjusted for entrepreneurial and price premiums. The natural interest rate is the interest rate that would prevail had there been no expansion of bank circulation credit.
In other words, in a fiat-money regime, where money is produced through bank circulation credit, the market interest rate is necessarily pushed to below the natural interest rate. And it is this discrepancy between the market interest rate and the natural interest rate that sets into motion the boom-bust cycle.[8]
The artificial lowering of the market interest rate induces additional investment. At the same time, savings decline and consumption increases. As a result, the economy starts living beyond its means. The boom is inflationary: all that has increased is the amount of money, not the supply of the means of production, such as labor and land.
The boom is economically unsustainable, because the policy-induced deviation of the market interest rate from the neutral interest rate causes malinvestment. Firms embark upon capital-intensive investment projects, and production becomes more time consuming, or roundabout.
The lengthening of the production structure implies a rise in the production of capital goods at the expense of consumer goods. The artificially suppressed market interest rate thus induces firms to engage in a kind of production that does not correspond to actual demand. As soon as this is revealed, the money-driven boom turns into bust.
The Problem Is Government Intervention, Not Capitalism
To sum up, in an unhampered market, the market interest rate (adjusted for risk and inflation premiums) is expressive of peoples’ time preference, and it corresponds with the natural interest rate. It allows for people allocating current income to consumption, savings, and investment in accordance with their true preferences.
In a fiat-money regime, where money is produced through bank circulation credit, the market interest rate will necessarily be pushed to below the natural interest rate as determined by peoples’ true time preference (that is, the pure interest rate adjusted for risk and inflation premiums).
This downward manipulation of the interest rate provokes an economically unsustainable boom, which must be followed by bust. Who can deny that the boom and bust is a consequence of fiat money — which is, in turn, a creature of government intervention in monetary affairs?
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Notes
[1] Fetter, F. A. (1905), The Principles of Economics, With Applications to Practical Problems, New York, The Century Co., Online edition by the Ludwig von Mises Institute, Auburn, US Alabama, 2003, p. 83; see also Fetter, F. A. (1915), Economics, vol. 1: Economic Principles, New York: The Century Co., Chapter 20.
[2] Mises, L. v. (1996), Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 483.
[3] Böhm-Bawerk, E. v. (1930 [1891]), The Positive Theory of Capital, G. E. Stechert & Co, New York, pp. 247–248.
[4] Mises, L. v. (1996), Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 484.
[5] Hoppe, for instance, distinguishes between external, biological, and personal/social/institutional factors. See Hoppe, H.-H. (2006), “On Time Preference, Government, and the Process of Decivilization,” in: Democracy, The God That Failed, Transaction Publishers, New Brunswick (U.S.A.) and London (U.K.), pp. 1–43, esp. pp. 3.
[6] Rothbard, M. N. (2004), Man, Economy and State, A Treatise On Economics Principles, Scholar’s Edition, Ludwigsing von Mises Institute, Auburn, US Alabama, p. 389.
[7] Mises, L. v. (1996), Human Action, 4th ed., Fox & Wilkes, San Francisco, p. 527.
[8] See, for instance, Mises, L. v. (1996), “The ‘”Austrian’” Theory of the Trade Cycle,” in: The Austrian Theory of the Trade Cycle and Oother Eessays, compiled by Ebeling, R. M., Ludwig von Mises Institute, Auburn, US Alabama, pp. 25–35.
