If people only had high time preference, we would probably still be in the Stone Age.
Increases in production are only possible through saving and capital formation.
Economic growth comes from people denying immediate
consumption for themselves in favor of more consumption in the future.
To correctly understand business cycles and where economic crises come from,
we need to understand two concepts: time preference and interest rates.
Time preference is the intensity of our desire to satisfy our wants now over
satisfying our wants in the future.
High time preference means that we want to satisfy our wants immediately.
For instance, we see something in the store, something that we were
dreaming about and we want it now, without waiting a single minute.
Low time preference means that we are able to hold off on our
consumption for now, in order to consume more in the future.
For example:
you want to go on vacation, but the only vacation you can afford right now
is a small and short one.
You decide to postpone your vacation so that you
can have a better and longer one at a later date, after you have saved more.
Another example: We want a decent life in retirement, so we decide to deny
ourselves something now and invest the money, so that we may have more
in the future.
Let’s talk about how interest rates should work in the market economy.
People save and spend their money, so they deposit and withdraw money
from banks continually.
In full reserve banking, banks would only be
responsible for keeping people’s money safe for a fee or lending only the
part that the customer would agree to lend.
In fractional reserve banking,
banks can lend a part of a depositor’s money and keep only fraction of it in
reserves, hoping that not everyone would want to withdraw their money at once.
In this scenario, banks can also offer their depositors interest on their deposit.
Thanks to that, banks are able to collect the money in order to give
other customers loans at interest.
The difference between the earnings of
the depositors and interest paid by the borrowers is the bank’s profit.
Now look at the money like is any other good.
What happens if a good is scarce?
According to law of demand and supply, the price of the good
increases, but where there is a lot of that product on the market, its price falls.
So, if people have lower time preference, when the vaults are full,
interest rates will fall.
Think of it as a money on sale.
When there is plenty of it, more people are able to get a loan from the banks.
Falling interest rates is a very crucial bit of information for entrepreneurs.
They see that
people are saving their money now, so there is a lot of capital available and
it is relatively cheap.
They also know that the real resources for new
projects are widely available, because people are not consuming them.
What entrepreneurs usually decide to do in this case is to make longer term investments.
As they increase their demands for the factors of production,
the prices of capital goods start to increase.
If interest rates were higher,
those investments would not be profitable because the interest rate might
exceed the return on investment.
In the case of low interest rates, those
investments are sensible and they provide a higher return than the interest rate.
This way, entrepreneurs can prepare for greater future consumption
since consumers have signalled this desire.
After all, greater future
consumption is the reason people save, and their lower time preference
was reflected in the lower interest rate.
Time preference can also go in the other direction, and savers could say:
“Well, we have saved a nice amount of money, now we can live more
comfortably by spending our savings”.
And the entrepreneurs can answer:
“That’s fantastic - we are ready - we have prepared for this by investing in
projects that are just now finishing”.
This mechanism contributes to balanced economic growth.
Time preference and market interest rates are really important because they
coordinate production in time.
While people refrain from spending their
funds immediately, those funds and the real resources are made available
to producers and entrepreneurs.
If people then increase their consumption,
the arrangement of capital and production (also known as the capital
structure) is capable of satisfying their desire to do so.
Standards of living
can grow because production is most effective when it is guided by this mechanism.
If people’s time preferences switch from low to high, the
money available for lending would become more scarce, and so interest
rates would increase, encouraging depositors to save more and
discouraging entrepreneurs from taking on long term investments.
Therefore, interest rates should be dependent on people’s time preference,
because only this way does it give important information about the
availability of real resources in the economy.
This way investments would
be based on real savings and there would be no risk that there will not be
enough resources to finish those investments.
In the absence of artificial interest rates set by central banks, there are no
boom/bust cycles, although fractional reserve banking could lead to some
problems even then, which will be discussed in another film.
Of course
there could still be some bad investments or slowdowns in some industries,
but there would be no economy-wide or systemic malinvestments.
Market interest rates give entrepreneurs all the information they need regarding the
general availability of resources for production today.
Artificially low or high
interest rates give them the wrong information about the availability of
saved resources.
In the next episode we’ll see why we have business cycles today and where
these spectacular crises come from.
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