Are Interest Rates Determined by Time Preference?
Time preference is your desire to sacrifice money now, for more in the future, or vice versa. Presumably, this determines interest rates— some people offer to lend money, others want to borrow, and they negotiate an interest rate. While this is one factor affecting interest rates, we need to look beyond time preference if we want to understand modern credit relationships and make them better.
In the Intro to MMT facebook group, someone asked if interest rates are determined by time preference. That is, are interest rates determined by markets pricing future vs. present consumption, for example, according to a supply and demand model?
Logically, people borrow because they prefer money now, and lend when they want more money later. Isn’t this the whole idea behind saving or investing?
MMT suggests a more general way to think about these decisions. This approach involves balance sheets. A balance sheet is simply an accounting record of all assets and liabilities. When we borrow or lend, or buy or sell, those actions are balance sheet operations, it changes what assets are available to us and what liabilities we are responsible for.
It’s not wrong to say “A borrower prefers money now”, but that observation does not give us the full picture of what they are doing with their balance sheet. Generally, people borrow money to buy something. They compare the cost of borrowing, both now and in the future, with the value they expect from their purchase, both now and in the future. Ideally, borrowing is beneficial both now and later, and not simply shortsided.
People borrow money to buy things, which they expect to provide them greater value, both now and in the future, when compared to the cost of borrowing. Ideally, borrowing is beneficial both now and later, and not simply shortsided.
Another reason why time preference does not determine interest rates, is because supply and demand, despite what conventional economics says, do not exclusively determine prices, even though they influence price changes and help markets trend toward a uniform price. Frequently, supply will expand to meet demand, or demand will shrink to available supply, without actually changing the price level. Prices are the social cost of resource acquisition, use, or ownership. Prices account for costs by regulating supply and demand, through social feedback.
Supply and demand do not exclusively determine prices, even though they play a role price changes.
Supply and Demand is a Social Feedback Mechanism of Control, Which Uses the Informational Channel of Prices, It is Not a Price Model
Conventional economics claims that Supply and Demand determines market prices, but this is wrong. Supply and Demand only affects prices in the margins, as a feedback mechanism. Control feedback mechanisms are self stabilizing systemic processes that maintain an equilibrium state, and while supply and demand keeps prices in equilibrium, other factors determine the equilibrium values about which supply and demand stabilizes prices.
Resource distributions exhibit the principles of political and biological evolution, not economics. If you already own something, its price is zero. Economics assumes an a priori resource distribution and value system — ownership already exists, it does not need to be hashed out politically through war or argument. Economics describes the impact of resource choices on marginal utility in the context of an assumed value system, whereas evolution and politics describe how value systems become established through population or social dynamics respectively.
Economics is a tool to assess the impact of resource decisions on predefined utility, it does not make ontological assessments about the morality or sustainability of our resource relationships and value systems. The analysis of economics is utilitarian, which means it assumes a fixed system of value, whereas evolution and politics use the analysis of economics to explore systemic developments of competing value systems. Evolution, politics, and morality use economics as a tool, not the other way around.
Certainly, utilitarian analysis provides us with deep and profound insights into morality. But the practice of economics requires a suspension of moral principles, precisely because you need to objectively assess the mathematical consequences of your values in order to understand their moral implications. We might say that economics is “Value Neutral” in that it can be used with any system of values. Economics does not ignore morality, it simply uses it as a parameter.
Interest Rates Are Not A Way For Those Who Show Restraint to Gain An Advantage Over Their Neighbor
Economic analysis does indicate that restraint can lead to certain advantages. But again, “advantage” is not an economic idea, but an evolutionary one. By definition, someone who values present consumption will always have higher utility by consuming more now, and that is the correct economic choice for them to make, even though it may not be a good moral or evolutionary choice.
Only when the benefit of restraint is universal, or at least without negative externalities, is it truly restraint. If showing “restraint” means being clever and resourceful enough to trick and subjugate your neighbor, or gain an unfair advantage, that is not restraint at all, but greed. And the hard earned knowledge of moral traditions are unequivocal about the long term negative results of such behavior.
A willingness to show self-restraint and sacrifice certainly sounds noble, but it only leads to a better results if two conditions are met:
- Mathematically, it is a better way to use resources, according to your established value system.
- Your value system is moral.
Economics is too frequently used as an excuse to hand wave away that second requirement. It is the moral character of greedy and selfish individualists to ignore the epilogical consequences of their actions. This moral character was created through evolutionary processes, but inherently, it is not adequate to sustain social groups and global health.
Greedy individualists ignore the epilogical consequences of their actions.
Fortunately, social groups have developed tools to combat selfishness and help protect our common well-being. Practices like rule of law, democracy, accountability exist for this reason.
Shortages Are Resource Allocation Failures, And Must Be Addressed Politically Or They Will Be Resolved Through Evolution (Selection).
A shortage is a condition where a resource is exhausted without meeting all applications under an established process of resource allocation.
In a market system, a shortage means the market has failed and it also implies a market failure when the greater political context is considered.
That may sound redundant, but a “Failed Market” is a breakdown of the marketplace, while a “Market Failure” is a specific type of inefficient resource allocation described by economics. A “Market Failure” means that resource allocations could be changed to make someone better off without making anyone else worse off. Again, it is assessed assuming predefined utility. Note that it is assessed in comparison with other outcomes as is the case with opportunity cost.
Initially, it would appear that shortages imply utility trade offs. Because the resource is limited, giving one person more means that someone else will have less. But politics exists precisely because there are ways to resolve resource trade offs in a way that leaves everyone better off in the end.
To improve the allocation of a resource that is a subject to shortage, you may have to take from one person to give more to someone else, but there are other channels and resources available to offset the lost utility of the requisitioned resource. If your resource allocation process can thereby satisfy everyone involved, it is not actually a shortage, as everyone is satisfied, and resource use is kept within limitations by the political allocation process, not by exhaustion of the resource. This is the potential value of politics.
In market systems, if they are functioning, people naturally adjust their resource utilization within limitations without political intervention using pricing. They use their balance sheets to express and resolve their utility preferences.
But when a market shortage exists, the price, would either go to infinity, or some market participants would exhaust all their available resources. For the individuals exhausting all their resources, these two events coincide.
In a market system, a market shortage and personal shortages always coincide, but do not necessarily involve a shortage of the same resource. For example, a market shortage of money(try as they might, someone can’t get any more money), might coincide with a personal shortage of food.
Shortages Are Not the Same Thing As Scarcity
When there is no scarcity, there is no reason to conserve resources, resource applications are not limited, and there is no reason to use economics.
It should be noted that “scarcity” can be created by negative consequences of resource use, and not only by limited availability of a resource. For example, if carbon emissions destroy the planet, we must limit our carbon emissions to survive, but not necessarily because carbon is limited.
On the other hand, shortages are a condition where a resource allocation strategy has failed. Scarcity limits our achievement of objectives, while shortages imply the violation of a constraint, usually a political or biological constraint which would affect the survival of a polity or organism respectively.
Money Is A Virtual Accounting Resource And Not Subject To Involuntary Shortages
The limitations on money are the informational limits of accounting. In other words, it is not the 20 trillion dollar national debt that limits money, but the minting and moving of copper pennies and computer bits. If we run out of information, we can always drop the least significant digits or coins, it doesn’t necessitate default.
For market systems to function correctly, money must always be unlimited, but also subject to costs. In other words, money should be subject to scarcity, but never subject to shortages. In this sense, money is subject to the second kind of scarcity. Like carbon, using too much can have negative consequences, even though the availability is not actually limited. (This is sometimes called “Artificial Scarcity”, but I don’t like that term).
To function correctly, money must always be unlimited, but also subject to costs. Money should be subject to scarcity, but never to shortages.
This makes it clear that the quantity theory of money is complete nonsense, as the money supply needs to constantly adjust to allow people to effectively express their balance sheet preferences at stable costs.
Two Types of Interest Rates: Investment Returns and Risk Premiums of Lending
Giving an account of interest rates is very difficult because they are such an ingrained part of our conceptualization of finance. But this becomes easier when we recognize that interest rates entail two very different things that get conflated by using a single term.
The two different aspects of financial relationships that we call interest rates, are the returns of investment and the risk premiums of lending.
We use investment returns to quantify the benefits of our balance sheet position over periods of time. This is useful for economically assessing and selecting long term resource strategies organized by different accounting entities. Financial assets are created to represent these resource strategies, and financial entities are established to perform and conduct the accounting involved in these resource strategies.
The other use of interest rates is to continuously charge someone else a premium over time to offset the cost, especially risk, of lending them money, in exchange for a greater promised repayment.
It is easy to see why these two types of interest rates get confused, because from perspective of the asset holder, they appear equivalent. But the other perspectives involved show how they are different.
Generally, a borrower accepts a specific repayment schedule, while an accounting entity accepting an investment commits to honor an issued accounting claim according to the rules of equity they have established.
Investment involves “purchasing” an asset because we expect it to benefit us over time. This often involves financial assets, which are virtual accounting constructs that grant claims which are honored by an accounting entity. Meanwhile, lending is allowing someone temporary use of a resource, or giving them a resource but requiring certain conditions of restoration, repayment or compensation over time.
Interest rates are a helpful metric when it comes to investment, because they take a complicated and unpredictable process, and give a simplified summary of the results. The net results of all your investments can be summarized with a single rate of return over time. But for lending money, exactly the opposite is the case. With lending, interest rates take a straightforward process of lending money and scheduling repayment, and obfuscate the important parts of the process. You don’t need interest rates to create a repayment schedule with incentives and or penalties, assess the net risk over the lifetime of the loan, or or describe the loan’s impact on your aggregate balance sheet position.
Because virtual financial assets, like modern money, are not subject to natural shortages, there is no opportunity cost associated with monetary allocations, each allocation must be considered separately. Therefore, charging interest over time for lending does not make sense, because there is no opportunity cost, and no need to outperform other investment opportunities. Credit worthy lending is inherently self limiting, because the real resource limitation is the time and labor of the borrowers in using the borrowed money or financial asset, not the ability of the issuer to informationally track accounting information. Lending should be evaluated on the merits of each loans. The premiums charged for borrowing only need to offset risk, and the penalties for breaking the schedule should be designed to maximize the borrower’s ability and inclination to repay. The combination of all risks on a balance sheet may need to be considered as well, as lending risks are often not probabilistically independent.
1. Money is not subject to natural shortages.
2. There is no opportunity cost when issuing money.
3. Credit worthy lending is inherently self limiting, as the real resource limitation is the time and effort of borrowers using borrowed money.
Conclusion
The goal of accounting should not be personal advantage, but rather accuracy. The idea that corporations or individuals exist to maximize profits is fundamentally wrong, and incredibly problematic. Corporations and other social entities exist to fulfill the purpose for which they were established. A pizza company’s purpose is to make great pizza. An airline’s purpose is provide an effective travel service. How did we get so far off the mark, that we think that all businesses are in the business of maximizing their social claims to wealth, even if it could have negative impact on the very system these entities depend on?
