In a recent column for Mises Wire, Doug French raised very important issue of negative interest rates. Quoting Fleckenstein Capital He wrote,
Yesterday a Parisian BBB-rated company (i.e., quasi junk) issued $500 million in three-year notes yielding negative 0.026%. We have been peppered with so many absurdities, nothing seems absurd anymore…
French continues with his own observations:
[The French utility company] Veolia Environnement S.A. floated €500 million of debt, rated just 2 notches above junk, with a three year maturity priced to yield negative 0.026%. As Grant’s Almost Daily writes, “Even better: Investor demand for the Veolia issue was such that the offering was oversubscribed by more than 4:1. Said another way, three out of four investors who wished to lose money on a yield-to-maturity basis were left disappointed.”
Clearly, this supposedly contradicts the view of important thinkers such as Mises and Rothbard that individuals always assign a greater importance to present goods versus future goods (i.e.. that interest rates must be always positive). This is also known as a positive time preference.
Before attempting to reconcile the apparent contradiction of the facts of reality and the positive time preference theory of interest let us have a look at the essence of this theory.
The Essence of Time Preference
As a rule, people assign a higher valuation to present goods versus future goods. This means that present goods are valued at a premium to future goods. Here is why.
An individual who has just enough resources to keep him alive is unlikely to lend or invest his paltry means. To this individual the cost of lending or investing is likely to be very high — it might even cost him his life if he were to consider lending part of his means. Therefore, under this condition he is unlikely to lend, or invest even if offered a very high interest rate.
Once his wealth starts to expand, the cost of lending, or investing, starts to diminish. Allocating some of his wealth towards lending or investment is going to undermine to a lesser extent our individual’s life and wellbeing at present.
From this we can infer, all other things being equal, that anything that leads to an expansion in the real wealth of individuals gives rise to a decline in the interest i.e. the lowering of the premium of present goods versus future goods.
Conversely, factors that undermine real wealth expansion lead to a higher interest. We can also, conclude that given the positive time preference the interest rate cannot be a negative figure.
We can thus conclude that the essence of the phenomenon of interest is the cost that a lender or an investor endures.
According to Carl Menger:
To the extent that the maintenance of our lives depends on the satisfaction of our needs, guaranteeing the satisfaction of earlier needs must necessarily precede attention to later ones. And even where not our lives but merely our continuing well-being (above all our health) is dependent on command of a quantity of goods, the attainment of well-being in a nearer period is, as a rule, a prerequisite of well-being in a later period……..All experience teaches that a present enjoyment or one in the near future usually appears more important to men than one of equal intensity at a more remote time in the future.1
Likewise according to Mises,
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
There is an apparent contradiction of the real world and positive time preference theory
According to the popular way of thinking, if an economic theory does not accurately correspond to the data then the theory is considered flawed.
Now, in the natural sciences whilst a scientist can isolate various facts he does not, however, know the laws that govern these facts. All that he can do is hypothesize regarding the “true law” that governs the behavior of the various particles identified. He can never be certain however, regarding the “true” laws of nature. On this Murray Rothbard wrote,
The laws may only be hypothecated. Their validity can only be determined by logically deducing consequents from them, which can be verified by appeal to the laboratory facts. Even if the laws explain the facts, however, and their inferences are consistent with them, the laws of physics can never be absolutely established. For some other law may prove more elegant or capable of explaining a wider range of facts. In physics, therefore, postulated explanations have to be hypothecated in such a way that they or their consequents can be empirically tested. Even then, the laws are only tentatively rather than absolutely valid.3
Contrary to the natural sciences, the facts pertaining to human action facts cannot be isolated and broken into their simple elements. The realities of human action are complex historical facts that have emerged on account of many causal factors.
However, we can ascertain the distinguishing characteristic and the meaning of human action. For instance, one can observe that people are engaged in a variety of activities. They may be performing manual work, driving cars, walking on the street or dining in restaurants. The distinguishing characteristic of these activities is that they are all purposeful.
Furthermore, we can establish the meaning of these activities. Thus, manual work may be a means for some people to earn money, which in turn enables them to achieve various goals like buying food or clothing. Dining in a restaurant can be a means for establishing business relationships. Driving a car may be a means for reaching a particular destination.
In other words, people operate within a framework of ends and means; they use various means to secure ends. We can also, establish from the above that actions are conscious and purposeful.
Various conclusions that derived from this knowledge of conscious and purposeful action are valid as well.
Note that the positive time preference theory is derived from the fact that people are using means to attain various goals in order to support and enhance their lives and wellbeing.
At any point in time, people have an abundance of ends that they would like to achieve. What limits the attainment of various ends is the scarcity of means. Hence, once more means become available, a greater number of ends, or goals, can be accommodated — i.e., people’s living standards will increase. This of course also, implies that with more means the cost of investing these means to individuals to attain various ends declines i.e. a lowering of time preference will emerge (see the discussion on this at the beginning of this article).
Contrary to natural sciences in economics we do not derive the theory from the data as such. Consequently, the theory, which is established, stands on its own regardless of what the so-called data is showing.
Since the theory stands on its own, it is employed to establish the meaning of the data. In our case, once we have established the validity of the positive time preference, we need to ascertain why the data could deviate from the theory.
As a rule a major factor for the discrepancy between observed interest rates and the interest rate that reflects people’s time preferences are the actions of the central bank. For instance, an aggressive loose monetary policy of the central bank leads to a very low observed interest rate. The aggressive monetary pumping however also undermines the real wealth formation process and works towards the increase in peoples time preferences i.e. to the increase in the underlying interest rate.
As the emerging positive gap between the time preference interest rate, which is not observed, and the observed interest rate widens, this ultimately leads to an economic bust.
Given the present distorted environment due to central bank policies, the emergence of negative interest rates does not contradict the positive time preference theory of interest rate determination. On the contrary, it enables an analyst to assess the severity of the distortions inflicted by central bank policies. Note that central bank activities have caused the increase in the underlying i.e. the time preference interest rate. This is established from the fact that activities of the central bank have weakened the wealth generation process. (Based on the positive time preference theory this must result in an increase in the underlying interest rate). Note that the theory does not enable us to quantify the underlying interest rate.
All that we can infer that the longer interest rates stay in the negative area the more severe the economic bust is likely to be. Note again that we do not derive the theory from the data as such but assess the data with the help of the theory. In our case, we have derived the positive time preference theory from the fact that people are consciously employing means to attain various ends.
Conclusions
The currently observed negative yields on some European corporate bonds supposedly runs contrary to the positive time preference theory. According to this theory, the underlying interest rate cannot be negative.
Following the fact that people are using means to attain their goals one can derive from this that the underlying interest rate must be always positive. The positive time preference is derived not from the data as such but from the general proposition that individuals are consciously employing means to reach various goals. The more means they have the more goals can be attained.
Contrary to the popular way of thinking, we do not assess a theory in respect to whether it corresponds to the data as such, but on the contrary, we evaluate the data by means of a theory. Observe that the theory is established from a non-contradictory proposition.
Because of various distortions, predominantly because of central bank activities, a positive gap between the time preference interest rate and the observed interest rates has emerged. If this gap were to widen further it is likely to lead to an economic bust.
- 1Carl Menger Principles of Economics, New York University Press p 153-154.
- 2Ludwig von Mises, Human Action 3rd revised edition, p 483-484.
- 3Murray N. Rothbard, “Towards a Reconstruction of Utility and Welfare Economics”, On Freedom and Free Enterprise: The Economics of Free Enterprise, May Sennholz, ed. (Princeton, N.J.: D.Van Nostrand, 1956), p3.
