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In assembling their capital resources, they take this time-related expense into account.

The Pure Time-Preference Theory of Interest

Therefore, in order to reduce the loss in value due to time preference, businessmen will always prefer the most efficient route available to final production. If, as is always the case today, a central bank commands through interest rate policy that the discount on future values is reduced, businessmen are no longer disciplined to prefer the most efficient route to production. The intertemporal discount is still there, but the suppression of originary interest rates by a central bank imposing a lower rate on the market creates an opportunity unrelated to the singular objective of providing consumer satisfaction.

This is why suppressing interest rates leads to malinvestments, exposed when interest rates subsequently rise. This is what the current hiatus in the stalling US economy is really about. It is clear, irrespective of monetary policy, that the originary interest rate is set by individuals in their roles as economic actors. That is not to say that in their decisions they are uninfluenced by official interest rates, but there is a tight limit to that influence.

Instead, individuals will seize the opportunities presented by the difference between their own originary rate of interest and that set by the monetary authorities. An obvious example is residential property, where supressed interest rates persuade individuals to borrow cheap mortgage money to buy houses, purely because the interest payable is less than that suggested by personal time preferences. The same is true of financing the purchases of purely financial assets, and it is also a key reason behind the expansion of consumer credit.

The suppression of interest rates to levels below those collectively determined by consumers in their time preferences is the fundamental source of inflations, booms, bubbles, and subsequent busts. That is in the lap of time preference, set semi-consciously by consumers. Taxation on interest interferes with time preference, which was demonstrated through its absence on savings in the two most successful post-war economies, those of Japan and Germany. Consumers in both Japan and Germany still retain a general savings habit that contributes to a relatively stable level of time preference, characteristics which have been central to their economic success.

The examples of Germany and Japan contrast with other socialised economies where savings have been discouraged through tax discrimination. The replacement of savings in the US and UK by bank credit and central bank base money has been a sad failure in comparison. And if savers realise the true extent that the currency of their savings is losing purchasing power instead of believing self-serving government statistics, they could be forgiven for discounting future satisfactions even more heavily. The expansion of bank credit does not slow, because the gap is still there and increasing as well.

We saw this demonstrated in the s, when rising interest rates failed to slow demand for credit, which continued to rise regardless. The rate of price inflation was also rising, persuading borrowers that the purchasing power of money was falling at an accelerating rate, thereby increasing their time preferences faster than compensated for by official interest rates. In the s demand for credit continued to increase, despite falling interest rates, because of financial and banking liberalisation which more than offset the failures associated with malinvestments.

Broad money continued to grow with minimal variation as if nothing had happened, as it still does today. The European Central Bank should pay attention to its failures as well. Its introduction of negative deposit rates, in defiance of all-time preference, has failed to stimulate production and consumption beyond government spending.

Admittedly, negative rates have not generally been passed on to businesses and borrowing consumers, often for structural reasons. It should be clear that negative interest rates cannot be justified so long as humanity values a satisfaction today more than the same satisfaction at a future date. While the evidence is that interest rate policies fail to regulate the pace of monetary inflation, the seeds of economic crisis were sown by earlier interest rate suppression.

The response by businesses is always the same: mothball or dispense with the malinvestments. Banks sense the mood-change in their customers and the associated increase in lending risk. The economy then runs into a brick wall with a rapidity that surprises everyone. Labour shortages disappear, followed by employees being laid off. An unstoppable process of correcting earlier malinvestments gathers pace.

To see what your friends thought of this book, please sign up. Lists with This Book. This book is not yet featured on Listopia. Community Reviews. Showing Rating details. Sort order. Mar 19, Zohair Ahmad rated it really liked it. I have been looking for a good explanation of interest. And the pure time preference theory does not disappoint. As always, the Austrian school goes to the logical root of the problem and explains how the phenomenon of pure time preference is both necessary and sufficient for interest.

The book then details other theories of interest and highlights issues that leave those theories inferior to pure time preference, which seems to be rock solid. The book is a bit hard to follow at times and I had I have been looking for a good explanation of interest. The book is a bit hard to follow at times and I had to read sections twice to completely understand every detail.

Definitely more of a scholarly work than a weekend read. There are no discussion topics on this book yet.

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Bill Stepp, Not only were there cycles before the Fed was created, but that were at least as bad as the cycles since we went off the gold standard. The Federal government could easily finance itself without the Fed.

The current state of play

Winton, Then Steve Horwitz should agree with me. Aaron Jackson and I published a paper arguing that with velocity futures there is no need for structural models of the economy.


Futures targeting gets around the lag problem. You say a fiat money system might work if well run, hmmm, that sounds a lot like a gold standard. Remember the gold standard of ? First of all, are you assuming the Fed determines interest rates? If so, you lose me right there. When the Fed tightened policy in December interest rates fell. Neither Keynesians or Austrians have a good explanation for that fact. Ratex economists do. JimP, Thanks for the link.

Books by Douglas E. French — Douglas in Vegas

Fundamentalist, Like many others here you are giving me a real explanation for a nominal variable. I thought the distinction between ex ante and ex post saving was a Keynesian idea. Do the Austrians also use it? I explains neither supply shocks, nor demand shocks. In my view demand shocks are caused by monetary policy moving NGDP up and down unexpectedly. That can occur just as easily in an economy with no banks at all. Changing NGDP and sticky wages explain it perfectly well.

Gibson’s paradox disproves the efficacy of monetary policy

In my view, the Austrian trade cycle theory is a confused understanding of the public finance elements of money creation. Public Choice economists including Wagner generally follow Buchanan in considering that taxes are imposed because somebody wants the revenue for some purpose.

Authors Forum: The Pure Time-Preference Theory of Interest - Jeffrey Herbener

There is a tax and spending program with the political system voters, politicians, etc. While financing true public goods is a possiblity, transfers are equally possible. Of course inflation impacts the allocation of resources. That is the point. If we think about some basic principles of public finance, and really just supply and demand, then generally, elasticities of supply and demand are less in the short run than in the long run.

If we imagine a constant tax rate, then the revenue from that rate will be greater when it is first imposed and then lower as adjustments are made.

Carry that over to the use of the revenue, then given a constant tax rate, the amount of goods and services that can be obtained will first be larger, and then smaller. What is the tax rate that provides the greatest revenue? Higher rates raise revenue from a given base, but higher rates lower the base. And a lower base lowers revenue. What rate, taking into account the impact on the base, generates the most revenue? That, of course, is the tax rate that will give those spending the revenue the greatest impact on the allocation of resources—producing things they want.

Think about the laffer curve for a excise tax—on beer for example—and not the income tax.