Sunday, November 7, 2010

Time Preference, Kim Kardashian, Quantitative Easing, Good Black Swan – 1 of 2

The depth, sophistication and musicality of Persian poetry is unmatched in any other language. Many of the great Iranian poets were believed in their time to have divine inspirations, so perfect is the fusion of form and content in their poems. And then there was the legendary spontaneity. A popular form of entertainment in the court or bazaar alike was throwing 4 impossibly unrelated words at a poet — toe, cow, ocean and Christ, for example — which he then used fil-bedaheh in a 4-line stanza to express an overlooked truth about life. Fil-bedaheh means on the spot, without thinking and contemplation. Such power I think had its roots in the poets’ philosophical and religious world view. If you believed that all things came from God, then all had commonalities, i.e., all were related. It was only the matter of perception of seeing the common link and the skill of putting them into a coherent whole.

The title of this post comes from that tradition, except that there is nothing fil-bedaheh about it. In fact, I made up the title after I had finished the piece, which is not quite the same thing! I, too, am a man of our time, writing in New York of 2010 where, like Ace Greenberg, everyone is looking for a little unfair advantage.


There is, in the standard economics theory taught to all freshmen, the notion of “time preference”. According to this conjecture, “people” — that would be all people: men, women and children everywhere — prefer “now” to “then”; they’d rather have $100 now than one year later. So if they wait one year to get the money, they would demand more, say $105, for their sacrifice. That is why interest rate exists! The difference between $100 now and $105 in one year is the 5% annual interest rate.


On Wednesay, the Federal Reserve announced phase II of its quantitative easing program (QE2), in which it will buy $600 billion of long-term U.S. government bonds over the next eight months. The idea behind QE2 is to “drive down interest rates and encourage more borrowing and growth”.


Gotcha, Ben Shalom Bernanke! Remember your Washington Post article, published just after the announcement of QE2 to soften the critics?
Easier financial conditions [by you pushing the rates lower via QE2] will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment.
Never mind that housing shows no sign of life. What is the story about lower corporate bond rate encouraging investment? You are saying that QE2 will spur growth because it will make money available to businesses now.

But if the rates are lowered, the time preference will be destroyed. That’s what you taught in your Princeton economics course. With zero or very low interest rates, there is no incentive to act now, because the difference between then and now is zero or very little. In that case, why would corporations choose to invest now instead of say, one year from now, huh? What do you have to say to that?


I believe in the narrowest interpretation of time preference: that in our mid to late 50s we tend to be more mature than third-graders. I know that it is not a general or inexorable law.


Between being hanged today and next year, people would choose next year. That is also true of having a colonoscopy, getting an eviction notice, losing one’s job and life's other unpleasantries. Why, the word procrastination would not exist if people always preferred “now” to “then”. But it does, thus pointing to the hidden hedonistic supposition behind time preference: it exists only in relation with acquiring and consuming pleasurable things. The mindset that conjures up time preference, in other words, is that of a Kim Kardashian or a Paris Hilton. The economists representing that mindset take the idea and dress it up in high language and mathematical notations for respectability. Paul Samuelson, whose name pops up whenever a vacuous idea comes up, was one of the most vulgar, and therefore the most outstanding, representatives of that lot. Look at the title of his paper and then read the drivel in the abstract to see what I mean.

Beyond empty-headed women and mountebanks, what gives rise to the illusion of time preference and helps sustain and institutionalize it is the commodity fetishism of a consumer society. That is why this moon-is-made-of-green-cheese nonsense that a first-grader could refute survives. No less than the “anti-establishment” author of the Black Swan divides black swans to good and bad groups. He calls Viagra a good black swan!

Here is a link to Wikipedia on time preference. Do not limit yourself to that site. Google “time preference” and take a look at some of the results — this one, for example, written by 3 inquiring minds from the nation’s premier institutions of higher learning — to get an idea about the level of scholarship and critical thinking in 21st century America.


There is no such thing as time preference in economics. Interest rates do not arise because humans prefer now to then. If that were the case, we would have billions of interest rates, corresponding to the subjective perception of every person on the planet. Quite the opposite: it is precisely because interest rate exists that time has “value”.

Interest is a deduction from profit. It is the share that finance capital claims from the profit of industrial capital. From Vol. 3:
When the rate of return of industrial and commercial capital falls, credit capital must likewise lower its rate. Otherwise, it would have to sit idle, having found no takers. Interest rates could indeed fall to zero and remain there for a long time if commercial or industrial capital cannot generate a profit. Under such conditions, they would have no reason to borrow, as borrowing would only aggravate the loss. In that regard, the Federal Reserve in the U.S. that raises and lowers interest rates to “cool down” or “stimulate” the “economy” merely reacts to market condition rather than shapes it.
These lines were written more than 5 years ago. What are the conditions now?


The industrial capital in the West has migrated to the East and South in search of lower labor costs and higher profits. (Capital has migrated, not its owners.)

Alas, the investment opportunities in the East and South cannot accommodate all the mass of ready-to-be-employed capital. So, a portion of capital in the West is left behind, sitting idle with no place to go.

That cannot go on. It cannot be allowed.


One way of generating employment opportunities for the idle capital is lowering labor costs in the West. If you are reading this in the Western hemisphere, everything you read in your local newspaper about economics and “politics” revolves around this issue. Cameron, Sarkozy, Papandreou, Zapatero, Cowen, Dombrovskis, even Merkel have no higher priorities. I have written about this issue. See, for example, here and here.

This idleness has a physical manifestation as well, but its most telling sign is the large pile of cash that corporations have amassed on their balance sheet.

Economics-professor-turned-the-Fed-chairman does not understand this process; at best he understands it superficially. He is trying to revive the activities of industrial capital by lowering the rates, fancying that with rates at zero or close to zero, the prospect of even low profit rate like 2% will induce corporations to borrow and invest. But the process is not reversible. Corporations cannot be induced to making investment – no matter how low the interest rates – if their investments would not generate income. That is why they have large spare, i.e., unused, capacity. Bernanke absent-mindedly admits that much when he writes that “low and falling inflation indicate that the economy has considerable spare capacity”. When corporations do not use the money they already have – because they cannot – what would they do with more money?


Corporations sitting on a large pile of cash which they cannot invest buy other corporations to benefit from “synergy”. That is the polite word for layoffs – hardly the stuff of economic recovery.


If QE2 will not influence investment decisions and economic recovery, what will it do?


Christopher said...

"The mindset that conjures up time preference, in other words, is that of a Kim Kardashian or a Paris Hilton."

That's a bit of a stretch. There are two broad reasons for a time preference. The first is simply that we have lives of limited duration, and during the course of those lives we AGE in something more than a purely nominal sense. Our bodies obey the second law of thermodynamics.

Thus, if you are a 20 year old with a chance at a professional athletic contract, it is a good idea (ceteris paribus) to take it now rather than next year. Nobody can predict with certainty the number of years during which your body will be able to play at a competitive level, but anyone can predict that there won't be an unlimited supply of them. So you prefer to get started.

Notice that this example isn't about consumption. It is about a particular employment relationship, and one's suitability for it. It is about production -- though what one is producing in this particular case is a spectacle rather than anything more tangible.

So the first reason for time preference: aging, with all it entails. Or, if you prefer: finitude.

The second reason? The processes of life in our fellow inhabitants of this globe -- in animals, plants, and fermentation-generating bacteria, etc. -- require time, and produce value when given that time. In other words: while we are aging, they are growing, breeding, ripening. Life doesn't merely succumb to the second law -- it resists that law.

Henry George developed this idea in the course of his critique of an illustration used by Frédéric Bastiat explaining the nature of interest and profit.

Bastiat wrote of two carpenters. One has built himself an extra plane, a crucial tool in the draft they share, and loans it to his colleague. Will he be satisfied with the return of as good a plane in a year? Surely not! He'd expect, Bastiat suggests, a board along with it, as interest. Never mind Bastiat's reasoning, I'd like to focus on George's reply.

George wrote, "I am inclined to think that if all wealth consisted of such things as planes, and all production was such as that of carpenters -- that is to say, if wealth consisted but of the inert matter of the universe, and production of working up this inert matter into different shapes, that interest would be but the robbery of industry, and could not long exist." But some wealth is inherently fruitful, like a pair of breeding cattle, or a vat of grape juice soon to ferment into wine, or a field of wheat. In each case, the processes of life themselves over time generate value.

Planes and other sorts of inert matter (and the most lent item of all—- money itself) earn interest only indirectly, by being part of the same "circle of exchange" with fruitful forms of wealth such as those, so that tying up these forms of wealth over time incurs a opportunity cost.

Notice that neither Bastiat nor George was discussing the sort of consumer impatience on which you would re-build the theory of interest.

So living generates a demand for interest (because organisms decay) and the processes of life also provide the ground for the supply of interest (because organisms resist decay).

Time preference then is a rational reflection of the realities of production.

Nasser Saber said...


The central point of the post is the absurdity of assigning value to astronomical time. Time, like space, is the condition of experience and precedes it. What would you say of someone who claims that "this side" of all the triangles is "preferable" to – and thus, "more valuable" than – the other side?

What about someone who claims that "now" is always preferable to – and thus, more valuable than – “then”?

In the latter case, there might not be a clinical madness. The person making such a claim is deluded but the nature of his/her delusion is social. It is the social environment that makes him/her believe that nonsense about the value of time. That social structure is the existence of capital and, from there, interest which, by virtue of having established itself in every aspect of life for the past couple of centuries seems like the natural order of the universe to the uncritical observer. It is in that context the preference for "now" is the mindset of a Kim Kardashian. The examples you give make that amply clear, starting with the people you quote.

Bastiat and Henry wrote about an obscure topic like the legitimacy of interest rate because they lived in the era of rise of Capitalism. The question of why a sum of money left under the bed does not increase quantitatively but it does at a rate of, say, 5%, when lent would not have occurred to medieval men. But neither man had the intellectual horse power to solve the puzzle. Witness George saying that he is "inclined to think".

It is not a matter of one's inclination. The subject matter of finance is not people. It is capital in circulation. The mechanism through which capital, itself a social concept, generates profit, is well known and well understood – not universally, but the material is out there for anyone wanting to learn.

Interest rate is the share of the "loot" that loan capital demands/extracts from other forms. People who are born into this particular socio-economic system naturally treat it as permanent and immemorial. Under such conditions, $100 now becoming say, $105 one year from now appears as something natural like sunrise. Why should that be the case is then explained by time preference; "now" must be more valuable than "then", so, those who wait must be rewarded for their abstinence.

But take $1,00 and put them in an interest bearing account. The money will earn interest long after its owners– the one with “time preference” – has died and turned into dust. Far from being a “rational reflection of the realities of production”, time preference is the manifestation of the false reflection of reality in human mind.

As for the second law of thermodynamics: aging is a biological process and has nothing whatsoever to do with time preference and time value. Animals also age. So do plants and planets, but I very much doubt that they charge each other interest or prefer now to then. Come to think of it, even humans don’t do it. How else could you then explain nostalgia? Just look at your examples and see how they are constructed around the socio-economic relations.

You conveniently start from the case of the professional athlete from the age of 20. Why not 5, or 3 or 1? These are all the same to astronomical time. It is the socio-economic system that assigns a "value" to the young man at the peak of his abilities because that is when they could best be exploited for profit. That is the meaning of "suitability". Your professional athlete is a just skilled worker who earns above the average salary because he produces above the average return. When that ability of his fades, he is discarded.

I take up all these issues in detail in Vol. 4, which reminds me I have to get back to the manuscript. But before that, I just remembered something about microloans in today’s New York Times that is relevant to this topic. Let me write a few words on it in the blog.