Time Preference and Net Consumption
24 November, 2015 1 Comment
Adapted from a Swedish blog post.
In case you are unfamiliar with these terms: “Time preference” refers to the fact that people (everything else equal) prefer a need satisfaction now or in the near future before the same need satisfaction in the more remote future. – “Net consumption” means the consumption of the capitalists, and the “net consumption theory” is the theory that the general level of profit in the economy is equal (or nearly equal) to the consumption of the capitalists. The theory is presented at length in George Reisman’s Capitalism: A Treatise on Economics, chapter 16.
Everything else equal, poor people have a higher time preference and – which is to say the same thing – a lower degree of future orientation than rich people. Take a homeless person, for example: he has to try to survive the day or the week; he is not in a position to set money aside for long-range projects or for his retirement. Another example would be a drug addict, whose time horizon is limited to his next “fix” – or an alcoholic who can only think of his next drink. – A less extreme example would be a poor farmer, who can only plan ahead for one year at a time; he needs this year’s harvest for him and his family to survive, and cannot put away more seed corn than is necessary for the next year’s harvest. (All farmers in Adam Smith’s “rude and early state” would be in this situation.)
At the other end of the spectrum, take a multi-billionaire such as Bill Gates or George Soros: he does not have to worry about surviving the next day, week, month, year or even decade; he can plan ahead for the future without having to concern himself too much with the present. He can even plan ahead for the time after his death and for securing the future of his children and grandchildren.
In between there are the rest of us: people with a moderate or fairly high income. We are in a position to set some of our money aside for the future: for buying a new house or a new car, providing for our children’s education, planning vacations, providing for our retirement.
But everything else is not always equal, so there are exceptions. A poor person may be struggling hard to get out of his poverty; and a very rich person may be squandering his wealth and end up poor.
If you are familiar with The Fountainhead, you may remember that Gail Wynand was sleeping on a couch in his office while building up The Banner and only later used his money to buy a yacht, create an art gallery, and commission a house from Howard Roark. – And for an example of rich people squandering their wealth, read Bernard de Mandeville’s The Fable of the Bees[1].
A change in the time preference of very poor people does little for the economy as a whole. Neither does such a change in the time preference of the few “squandering rich”. It is the time preference of the well-to-do and the industrious rich that makes a difference. As long as those people have a low time preference and a correspondingly high degree of future orientation, they will invest their money, and it is those investments that move the economy forwards.
According to George Reisman’s theory, the level of profit in the economy as a whole is equal to the net consumption of the capitalists (I leave net investment aside, because I don’t think it changes my point). As long as the capitalists have a low time preference, net consumption stays at this low level; the greater part of their wealth goes to productive investments. And the richer they become, the lower becomes their time preference, the more gets invested, the more gets produced, the more workers get employed and the higher their wages become.
But assume that the capitalists’ time preference would increase (and their future orientation would correspondingly diminish); this could happen if there were to be a serious threat of confiscation of their wealth by a socialist government (or if there were certain indications that doomsday was approaching and the world would come to an end). Then the opposite would happen: they would consume their wealth instead of investing it; production would diminish or cease altogether; unemployment would rise; and so would the general level of profit and interest.
And this is why time preference is not a direct but an indirect cause of the level of profit and interest. It works through the net consumption of the capitalists.
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Update December 26, 2015: As George Reisman has pointed out to me in a private message, it is not entirely true that capitalists will continue saving and investing indefinitely. As long as a capitalist is building his fortune, he will save and invest heavily out of his income and consume correspondingly less. But once his fortune is sufficiently large to make his own future – and even his children’s and his grandchildren’s – secure, he will have no incentive to further enlarge it, so he will save and invest less and less and finally may come to the point where he will consume all of his income. (For an extensive discussion of this, see Capitalism: A Treatise on Economics, pp. 739–744.)
I think (this is my own reflection) that this explains why so many of the greatest capitalists establish educational or other foundations (for example Rockefeller and Carnegie, and today Bill Gates and George Soros). From the point of view of the capitalist, this is consumption, since the purpose is not to make more money and enlarge his fortune, but simply to make the best use of the money he no longer needs.
George Reisman also tells me that
capitalists continue to save to the extent that the rate of profit/interest exceeds the rate of their consumption (the rate of net consumption). What causes this is the continuing increase in the quantity of money and volume of spending in the economic system. If the quantity of money and volume of spending ever stabilized at some given level, accumulated capital would grow to the point at which the consumption of the capitalists exhausted the whole of their incomes; at that point, saving out of income would be zero.
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The honor of having discovered the role of time preference goes to Eugen von Böhm-Bawerk. Later “Austrian” economists, such as Mises, have considered his explanation of the causes of time preference as not quite satisfactory. But the one who nails it is, once again, George Reisman:
The nature of human life implies time preference, because life cannot be interrupted. To be alive two years from now, one must be alive one year from now. To be alive tomorrow, one must be alive today. Whatever value or importance one attaches to being alive in the future. one must attach to being alive in the present, because being alive in the present is the indispensable precondition to being alive in the future. The value of life in the present thus carries with it whatever value one attaches to life in the future, plus whatever value one attaches to life in the present for its own sake. In the nature of being alive, it is thus more important to be alive now than at any other, succeeding time, and more important to be alive in each moment of the nearer future than in each moment of the more remote future. If, for example, a person can project being alive for the next thirty years, say, then the value he attaches to being alive in the coming years carries with it whatever value he attaches to being alive in the following twenty-nine years, plus whatever value he attaches in the coming year for its own sake. This is necessarily a greater value than he attaches to being alive in the year starting next year. Similarly, the value he attaches to being alive from next year on is greater than the value he attaches to being alive starting two years from now, for it subsumes the latter value and represents that of an additional year besides.
The greater importance of life in the nearer future is what underlies the greater importance of goods in the nearer future and the perspective-like diminution in the value we attach to goods available in successively more remote periods of the future. (Capitalism: A Treatise on Economics, p. 56.)
To put it in shorter words: To be alive today and this year is the necessary pre-condition of being alive tomorrow or in fifty or a hundred years. Everything else equal, we have to value life in the present over life in the future, for if we don’t, there will be no life in the future. Thus we have to have goods or money to survive the day before we can start thinking about saving for the future.
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I originally wrote this some years ago, when I was pulled into a discussion with an idiot not too well-informed person, who claimed that George Reisman could not be a real “Austrian”, since he does not share the conventional “Austrian” view om time preference.
(Other schools than the “Austrian” have no inkling of the role of time preference.)
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See also my earlier blog post Christianity and Time Preference.
[1]) Mandeville claimed that this squandering would be a boon to the economy; but this is simply a version of the “broken windows” fallacy and has been refuted time and again by better economists.