The Myth of Time Preference By Bryan Caplan

How come interest rates are always positive? Austrian economists have a stock answer: it’s because of time preference. All else equal, we prefer satisfaction sooner rather than later. If we did not have time preference, we would never consume anything, because we would keep delaying consumption. As Mises puts it:

We must conceive that a man who does not prefer satisfaction within a nearer period of the future to that in a remoter period would never achieve consumption and enjoyment at all.

Unlike a lot of Austrian doctrines, this view is plausible. But it’s wrong nevertheless. You don’t need time preference to get people to divide their consumption between today and tomorrow; all you need is diminishing marginal utility. 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.

But if diminishing marginal utility is a sufficient explanation, how come the price of consuming now is always greater than the price of consuming later? Don’t you need time preference to explain why interest rates are always positive? Not really. Gold has (almost?) always been more expensive than silver, but we don’t need to postulate “gold preference” to explain this pattern. The greater scarcity of gold is all the explanation we need.

But before we try to explain why interest rates are always positive, we should make sure that they are always positive. In barter markets, interest rates are frequently negative. Suppose we knew the price of food would double next year. Then a pound of food now trades for half a pound of food one year from now. Translation: a negative 50% interest rate!

If this seems crazy to you, suppose food were the only commodity, and you expect a famine next year. Wouldn’t you happily trade 2 pounds of current food in exchange for a promissory note good for 1 pound of food next year?

When you put it this way, it isn’t too hard to figure out why interest rates on money are always positive. Unlike food, money doesn’t spoil, and costs almost nothing to store. So if the interest rate fell below 0%, lenders would simply hold their money instead of lending it. (This also explains why inflation-adjusted interest rates on money often are negative. Lending money at 5% when inflation is 10% is a better deal than sitting on it).

Focusing on time preference also leads Austrians to miss another important reason that pushes up interest rates: economic growth. In the modern world, the typical person gets richer in the typical year. Once again, this gives even perfectly patient people a reason to increase their demand for current consumption. Imagine you are going to inherit $1,000,000 next year. According to the law of diminishing marginal utility, you would want to increase your consumption now when the marginal utility is high, and pay for it by cutting back your consumption in the future when the marginal utility is low. No time preference story need apply.

Of course, none of this means that time preference does not exist. It does. But you don’t need it to explain the existence of interest. Diminishing marginal utility does that job. And you don’t need time preference to explain why interest rates are always positive. Many aren’t; and the ones that are always positive involve products that don’t spoil and don’t cost much to store.