A Defense of the Time Preference Theory of Interest: A Response to Machaj

The economic question of interest is the most persistent topic of debate in the history of economic thought. From debates on its legitimacy amongst the scholastics to the modern divisions on its ultimate source, it seems as if the topic of interest will never be quite “settled science”. Even among the Austrian School of Economics, where the majority of the tradition is in agreement on such questions, dissension to this majority view is anything but uncommon. Dr. Mateusz Machaj is one such skeptic. In his book, “Money, Interest, and the Structure of Production”, Dr. Mateusz Machaj questions the validity of the time preference theory of interest and its explanatory ability. The core of his claim is that the time preference theorists have not satisfactorily shown why it is that there should be a necessary link between time preference and the necessary interest residual first pointed out by Bohm-Bawerk. Because this link has never been solidified, time preference per se cannot serve as a basis for an interest rate theory. If Machaj is correct, then his argument exposes a serious, and potentially fatal, flaw in the pure time preference theory of interest.

To capture some of the finer points of his argument, it would be beneficial to quote him at length. Machaj writes:

“Let us put aside those details and return to the fundamentals of action. By virtue of taking any action, people demonstrate their valuation of time, which needs to be economized on. Any choice made by an individual represents a will to act now rather than later. With this adjustment, all of Mises’s points become more universal. After all, a choice is always a choice to act now — not later, not in the distant future. Hence, time is always valued as a scarce good that is in irreversible flux for humans. Yet, despite such adjustment, there is still a gap between making time preference an element in a pure theory of action and making it a prerequisite for physical monetary surplus. Actually praxeological time preference does not imply positive time preference (Gunning 2005, p. 106).

Consider a typical interest exchange where 100 units of money are given up in order to receive 105 units of money a year from now. The receiver of 105 units, by virtue of their choice of cashing out, demonstrates a preference for receiving the money in twelve months’ time — not in thirteen months, fifteen months, or longer than that. Such a clear preference for accepting the good sooner rather than later comes from the praxeological nature of exchange as action occurrence. Nevertheless, there is no clear bridge between a preference for sooner rather than later and a physical surplus of money in interest payments. The transaction could well be 100 units of money today in exchange for 100 units tomorrow, such that monetary interest is zero. Or interest could even be negative: 100 units today for 95 units tomorrow. We do not argue that such an exchange is likely to happen or is normal: there are good reasons why a physical monetary surplus does occur in interest payments and good reasons why it leads to beneficial results in the market process. But there is no a priori, or praxeological, reason why zero or negative money interest should not happen because of some particular notion of time preference. There is obviously some missing link between the two” (pg. 25–26)

What Machaj is calling attention to in these two paragraphs is a gap that he claims time preference theorists have not filled. They have contended themselves with demonstrating the concept of time preference in action and then clumsily applying this idea wholesale to a theory of interest. However, they have not satisfactorily shown that the two are actually connected to each other. Later on in the book, Machaj posits his own theory of interest, which is based on the concept that interest is a return to money itself for the services it provides in facilitating the production process. Discussion of that theory, however, is a topic for another day.

Putting aside the claim of whether or not time preference can serve as a theory of interest, is Machaj correct that writers in the Austrian tradition failed to demonstrate this relationship in their writing? While there are a variety of writers in the Austrian tradition — all of whom take their own approaches to the subject of interest — Machaj is largely correct. In many of the great Austrian treatises and works on interest, the writers have largely assumed that one can move seamlessly from a discussion on time preference to a discussion on interest without thoroughly demonstrating how the two are linked. Even so, this does not at all mean that such a demonstration is not possible. It simply requires that we elucidate a theory of time preference in a rigorous, step-by-step manner and apply this theory to arrive at a coherent theory of interest, finalizing the link between the two.

First, what is time preference? As Machaj himself points out, time preference is the simple concept of acting now rather than acting later — of preferring the present to the future. In more precise terminology, we might say that time preference is the preference of a given satisfaction in the present as opposed to that same satisfaction at some point in the future. Simple enough, but from where does time preference originate? This is our first point of difficulty, as different authors in the Austrian tradition have often had different answers for the origination of time preference. Mises emphasized in Human Action the need for man to economize his time (Section 1, Chapter V). Rothbard in Man, Economy, and State emphasized the desire for man to achieve his end as soon as possible (Chapter 1.5). While these and other writings on time preference are not mutually exclusive and can largely be reconciled with each other, their differences are apparent to anyone who reads them. Given the delicate nature of our inquiry, perhaps it would be best to return to first principles.

Time preference is a necessary implication of the Praxeological structure of action. Human beings act, meaning that they utilize means for the attainment of ends. Action is only possible if there is change, and change is only possible if it is taking place in an inter temporal sequence. Consequently, action itself is a temporal phenomenon, and any actor must make distinctions between the past, present, and future. The root cause of action is uneasiness, which can be described as a desire to alter a future state of affairs. Just as action is intertemporal, so too is uneasiness. Without the passage of time, there would be no way to change the future. As a result, uneasiness is not just felt in the abstract, but felt over a length of time. To then say that an actor wishes to alleviate uneasiness is equivalent to the statement that he wishes to alleviate that uneasiness as soon as possible. In other words, an actor would prefer a certain satisfaction in the present versus having to wait for the same satisfaction to arrive at some point in the future, as doing so would only compound his felt sense of uneasiness. It is this conclusion that is the essence of time preference.

Machaj holds a different view on the relationship between action and time preference, which has no doubt influenced his view on the question of interest. As quoted above, Machaj writes,

“By virtue of taking any action, people demonstrate their valuation of time, which needs to be economized on. Any choice made by an individual represents a will to act now rather than later. With this adjustment, all of Mises’s points become more universal. After all, a choice is always a choice to act now — not later, not in the distant future.” (Pg. 25)

While not explicitly stated, Machaj seems to be thinking of time preference as being a near-trivial aspect of action. When people decide to act, they are demonstrating their time preference by acting now instead of acting in the future. If this is all time preference is, then Machaj’s belief that there is an unbridgeable gap between time preference and interest is perfectly understandable. Yet time preference is not merely an ex post conclusion from an individual’s action — it is an inseparable category of action itself. More importantly, time preference is a necessary response of actors to uneasiness as it is felt through time. It is precisely this necessary response that gives us the basis of interest.

The kernel of the problem of interest was most lucidly raised by Bohm Bawerk, as Machaj himself notes. Bohm Bawerk asked why there exists a constant return on markets that is never arbitraged away. For instance, a machine that provides ten years worth of services worth $100,000 per year may only be sold for $800,000. This machine will generate $1,000,000 of revenue, but costs only $800,000, leading to a net return of $200,000. Every other opportunity to earn a net return on markets is quickly taken advantage of, but these returns never seem to be exhausted along with all other arbitrage opportunities. Why is this the case? Answering that question is the impetus which has led to all the bountiful variety of theories of interest. However, before we address interest returns specifically, we should first examine the more general subject of returns on markets as a whole.

Despite its importance, it is rarely ever asked in an economics classroom why it is that things cost money? While such a precocious question might seem beneath the dignity of economics, the gravest flaws are often found in the simplest mistakes. The reason why one has to pay for goods and services is because the people providing those goods and services do not want to give them away for free. They expect payment in return. These payments are requested because surrendering goods and services to customers carries an inherent cost. In other words, there is uneasiness created by providing these goods and services to others. This results from the fact that the goods and services that are given up could have been used as means for alleviating uneasiness. The baker that sells his bread could have eaten that bread himself. The bricklayer who spends an afternoon building a house could have spent that time building a house of his own. In order for these producers to consider giving up these goods and services to others, they must be compensated for doing so. In order to incur the uneasiness this brings on, they must receive something else to relieve uneasiness in return. Speaking in strict economic terms, we would say that they must value what they receive for their goods and services more than the goods and services themselves.

The money that these producers receive from trading their production on markets represents the return they accrue for the value they have provided. Workers earn a return from the labor they perform, renters from the services of land, capitalists from their capital goods, and entrepreneurs from being smart enough to put it all together. In general terms, we can state that the reason these economic returns exist is because of the uneasiness generated by performing them.

This catallactic logic also applies to interest as well. We have shown above that the postponement of satisfaction from the present to the future will always result in greater uneasiness than present consumption. Therefore, whenever an individual makes an intertemporal exchange where he exchanges potential satisfaction in the present for satisfaction in the future, uncertainty is necessarily created. The only reason why someone would be willing to incur that uneasiness upon themselves in the present would be the promise of a greater satisfaction in the future — an increased sum of money than the sum originally given up. Just as every other return is a product of inducing an individual to take on uneasiness for the sake of a greater preferred satisfaction, so too is interest the payment rendered to compensate the uneasiness incurred by surrendering present satisfaction for future satisfaction.

It is this inherent uneasiness created through postponement that is the “bridge” between time preference and interest theory. Machaj misses this crucial aspect of time preference because his conception of the temporal aspects of action is almost entirely devoid of uneasiness. If time preference is just an actor’s acting now as opposed to acting later, then it is hard to see how uneasiness fits into this picture in any meaningful way. Time preference, however, is fundamentally a creation of uneasiness. Any attempt to describe it without making reference to the satisfaction forgone by delaying that satisfaction is vacuous at best, and misleading at worst.

Putting aside the question of interest and its derivation, Machaj does raise another stimulating point that has been often overlooked by interest theorists. He asks why it is that an interest payment necessarily and always has to be positive. Why is it that someone doesn’t exchange 100 units of money for 95 units a year from now (assuming the purchasing power of money remains constant)? Such exchanges are not likely, but there is no necessary reason why someone could not conceivably make such an exchange. Excluding any conditions of a rising purchasing power of money, how is interest theory supposed to internalize such possibilities?

The answer lies, once again, in our catallactic theory of market returns. Just because a return can be earned on a market doesn’t mean that return is always realized. For example, a worker may apply for a job requesting that he is paid absolutely nothing for his labor. In other words, he will earn a wage of $0. This uncompensated employee certainly could earn a wage if he wanted to, but for some has decided to forgo it. Now, in order to overcome the uneasiness of performing this labor, there still must be some utility provided to such an individual, whatever that utility may be. Perhaps he is serving out a self-inflicted punishment, or he might be a devotee of radical asceticism. In any case, the same situation applies to interest returns as well. Someone very well could exchange 100 units of money for 100 units of money one year in the future. What this represents is an unrealized interest income that could have been realized, but for some reason or another, has not been. This refusal to receive an interest payment does not invalidate interest returns as whole or undermine our explanation for their existence. All it means is that we can explain why interest exists — the necessary uneasiness generated by the postponement of satisfaction into the future — but that there are some individuals who simply do not wish to partake in this potential monetary gain and make these returns for some other reasons.

It is the hallmark of a weak theory that it refuses to respond to opposing arguments. For those ideas that are sound and true, the crucible of criticism only makes those ideas stronger. I believe that Machaj’s attacks on the time preference theory of interest have performed precisely this service. While Machaj is mistaken in his conclusions, his assertion that there has heretofore been a gap in the exposition of time preference and interest is largely correct. Fortunately, this gap is bridgeable with sound economic reasoning. The failure of previous time preference theorists to make this connection explicit was not the result of a weak argument, but a lapse in their rigor and precision. While such lapses are unfortunate, they are to be expected in a sense. No scholar is ever perfect, and all each generation can hope to do is to stand tall upon the shoulders of the giants who came before. While our current formulations of economic theory — and particularly the subject of interest — doubtless contain errors that will be exposed by future generations, all that we can ask of ourselves is that we are good and faithful stewards of the truth; and labor to the best of our abilities in maintaining and building upon the intellectual edifices that have been passed down to us.