Back in 2005, Bryan Caplan wrote an article entitled “The Myth of Time Preference”.  In it, he purports to explain, well, why time preference – the Austrian concept that people prefer satisfying their ends now, as opposed to later, all else equal – was just a myth.

In the article, Caplan proceeds to demonstrate that he has no idea what the concept is whatsoever. To start his explanation of why time preference is, in his view, an error, Caplan begins by saying:

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.

Here he has already made many errors.  The banana story actually begs the question. He specifically declares that “a patient person” (by definition, a person with a low time preference) will ration the bananas, and he points out you don’t seem to need time preference to explain the behavior of a person with a low time preference. But a low time preference is what patience is – someone with a high time preference would eat both bananas today.  Time preference would be an opposing force here – it would mean a person valuing satiating his hunger now more than satiating it tomorrow. Caplan assumes here precisely what he is attempting to argue for – the lack of time preference.

Additionally, he purports that this person values satiating his hunger today and tomorrow equally.  But there are degrees of satiating hunger.  Perhaps one banana isn’t enough.  Perhaps he doesn’t even need that much.  When is his hunger actually satiated, such that – given as much food as desired – this man would stop eating?  Will that point be the same tomorrow?  (No, of course not.)  The future is speculative, and that aspect of it cannot be removed from the equation. He continues with a comparison of gold and silver prices:

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 is there a greater scarcity of “now” as opposed to “later”?  Again, there is not.   (In fact, if anything, one can only say there is a “now”, and that “later” may or may not exist at all for each person.)  Thus this explanation is irrelevant. There is no “supply and demand” of time, and thus no supply and demand explanation of greater prices for present consumption.  Instead, we must find another explanation.

Further, what he seeks to do is faulty here.  The greater scarcity of gold is not “all the explanation we need”.  We also must include “gold preference”, in the form of demand for gold.  If there is no preference for the possession of gold, there is no demand – and thus no price, no matter how scarce.  The only way time preference differs from “gold preference” or “steak preference” or preference for any good or service is that time is particularly difficult to classify as anything but itselfCaplan then goes on to explain that interest rates are not always positive, after all!  At least, under certain circumstances:

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?

Here I’m surprised at Caplan – surely he knows better than this. Any time-preference-touting Austrian will tell you that the market interest rate is aggregated time preference plus an inflation premium (in a money economy – Caplan curiously chose a barter economy, but bear with me) because the seller doesn’t want to be paid back with less purchasing power than he lent out, if he’s expecting price inflation. And we always throw in the parenthetical, “which could be negative in the event of expected price deflation”, possibly resulting in negative interest rates.  (Of course, a zero interest rate would cease lending, so that’s as low as it would go in a monetary economy.) So, all he’s done here is point out an opposing force which Austrians also point out – that of speculation regarding future results – capable of canceling out the effect of time preference on market interest rates. What Caplan needs to do here is show whether interest rates could ever be zero or negative without the expectation of price change, and he can’t. If I have a thousand dollars and the choice to spend it now or lend it to you, I’m going to need interest on the loan such that I can buy more next year when the loan is repaid than I can now.

It is interesting, though, that Caplan chose a barter economy to make a note of his negative interest rates.  Except he actually didn’t.  He made assumptions regarding the price of food. But once we have a price, then we are no longer in a barter market. What we are doing now is speculating. But even if we assume that this is true, the interest rate is still not negative. Food now, given current conditions, is not the same as food a year from now, as conditions will change.  Even taking that at face value, he admits that the monetary value (in terms of price) is the same for both trades, meaning the interest rate was actually zero.  He is conflating two events that exist simultaneously – time preference and changing supply/demand factors – and saying this disproves the existence of one. That’s like saying because my bathtub drains as I pump water into it, the faucet is a myth!

His note of the famine especially seems strange.  I’m surprised to see him point this speculative action out, as it’s a major weakness in his argument, which repeatedly uses food. The expected deterioration of a good available for consumption now but not later will obviously affect my consumption pattern – it’s a complicating factor, not unlike the expectation of inflation, and he’s consistently using it to demonstrate something Austrians already know. Of course I’ll eat the bananas today if I expect them to be rotten tomorrow, for example, regardless of time preference, because it renders their future consumption impossible and irrelevant.  (It’s almost as if the concept of ceteris paribus eludes Caplan’s grasp entirely!) His next bit is highly flawed, to the point where it is questionable whether Caplan has thought through his position much at all.  To start, he says:

Focusing on time preference also leads Austrians to miss another important reason that pushes up interest rates: economic growth.

This is just simply wrong.  Economic growth doesn’t push interest rates up at all!  It pushes them down! The only way one could get this backwards is by assuming the bubbles we have experienced periodically are normal economic growth, and not the result of malinvestment and inflation.  (Which Caplan does, of course, but mainly because he utterly misunderstands the Austrian insights into economics.)  To quote Frederic Bastiat on the subject (emphasis added):

“What is Interest? It is the service rendered, after a free bargain, by the borrower to the lender, in remuneration for the service he has received by the loan. By what law is the rate of these remunerative services established? By the general law which regulates the equivalent of all services; that is, by the law of supply and demand.

The more easily a thing is procured, the smaller is the service rendered by yielding it or lending it. The man who gives me a glass of water in the Pyrenees, does not render me so great a service as he who allows me one in the desert of Sahara. If there are many planes, sacks of corn, or houses, in a country, the use of them is obtained, other things being equal, on more favorable conditions than if they were few; for the simple reason, that the lender renders in this case a smaller relative service.

Is it not surprising, therefore, that the more abundant capitals are, the lower is the interest.” – Capital and Interest

And, of course, the “service rendered by the receipt of the loan” is the satisfaction of a higher time preference, in addition to speculative concerns regarding the present state of affairs as opposed to the future.  But it simply makes sense that the supply of loanable funds increasing will decrease monetary interest rates – this is how the Fed lowers interest rates by creating new bank reserves in the first place. He carries on with this strange warping of reality:

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.

It is true that with economic growth, some people get so much richer that “even perfectly patient people” will increase present consumption. This is amazing, because he’s restating our position without realizing it (again, patience is low time preference) and even doing Austrian-style deduction from it. What he’s saying is just what an Austrian would say – if my income goes up, my present consumption will increase even if I have a very low time preference precisely because I can do it without sacrificing future consumption, which can increase at the same time.   Recall that time preference implies that if I have a preference, I will value higher satisfying it now as opposed to at some future time (and that it will be less valued the further away that time is).  In terms of an ordinal preference scale, it would look something like this (we’ll simplify our scale to only apples):

  1. First apple now
  2. Second apple now
  3. First apple in 1 year
  4. Second apple in 1 year
  5. Third apple now

(The astute reader will of course note that we left out potential bundles of apples – for instance, “2 apples now” or “3 apples in 1 year”.  This was done to help point out the increasing present consumption with time preference, without the potentially confusing factor of bundled goods.  The same analysis could be done with such bundles, however.)

As we can see, if the individual only can afford the top three preferences, he will get two apples now and makes a loan of some kind for the apple in 1 year.  If we find he becomes wealthier, and can now afford all five preferences, we see that both his future (expected) consumption and his present consumption increase.  But time preference still applies, and it still explains why he would choose the first apple now over the same preference (a single apple) a year from now – meaning that if it were increased to 2 apples, he may choose that first.  Thus, giving us a time preference explanation for an interest bearing loan by looking at two individual’s preference scales.

Person A

  1. 2 apples in 1 year
  2. First apple now
  3. First apple in 1 year
  4. Second apple now

Person B

  1. First apple now
  2. 2 apples in 1 year
  3. Second apple now
  4. First apple in 1 year

The differing coincidence of wants between the first two preferences of these individuals would lead to A loaning B the first apple he obtains in exchange for an IOU for two next year (a 100% interest rate).  This is the source of loans, and thus interest – differing levels of time preference mean some people benefit from lending and others from borrowing to better satisfy each person’s preference.

Caplan then proceeds to state:

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.

Marginal utility does not apply here.  Consumption now and consumption in the future are completely different preferences.  Diminishing marginal utility implies that the next unit of a good will be used for the next lowest preference.  It says nothing of which use is preferred.

Diminishing marginal utility does not “explain interest”. It does nothing of the sort on its own. And the Austrian explanation is that current consumption increases until the diminishing marginal utility is matched by the discount due to time preference, and using the good to satisfy a preference at a later date is now more valuable than a use of it now. Caplan here fails to understand the concepts of time preference and speculation, how it applies to interest, and even misapplies the basic concepts of supply and demand and marginal utility.

To be fair, Caplan has done some great work, and some of that work is very worth looking into such as “The Myth of the Rational Voter“, “Tough Luck“, “Crazy Equilibria: From Democracy to Anarcho-Capitalism“, and much more. But like his other critiques of Austrian Economics that fall short, this may go to show that perhaps Caplan should leave the Austrian Economics to the Austrians.



In Liberty,

Jeff Peterson II and Matthew Tanous


We the Individuals