The Payment for Waiting: Time Preference

The Payment for Waiting: Time Preference

von Bohm-Bawerk Developed at the same time as the productivity theory was an­other theory with which it was later linked to provide the most popular explanation of interest and interest rates. This was the time-preference theory, that is, the theory based on the conten­tion that because present goods possess superior value over future goods a payment must be made for waiting. In his definition of capital as abstinence, Nassau Senior turned attention to the factor of waiting. In order to create capital it was necessary to abstain from present consumption. Abstinence was not pleasant, there­fore payment was necessary in order to cause persons to endure the discomfort. No distinction was made among English econo­mists between interest and profit, consequently it was assumed that waiting might be responsible for either one or the other or both. John Stuart Mill built upon the work of Nassau Senior and John Rae in elaboration of this point but he made no modifica­tions of the general theory.

It was von Bohm-Bawerk who made the synthesis of the time-preference and the productivity theories of interest. After a laborious description and frequent criticisms of existing theories of capital and interest he proposed his own positive theory. He accepted the proposition that man generally prefers present to future values, although this might be greatly modified by the character of the individual and the security of the environment. He claimed, in addition, an economic as well as a psychological reason for present values being greater. Since the function of capital is to increase the productivity of labor, an article made today will have greater value than the same article in the future, as its cost of production is greater today. Because of these facts people were willing to pay extra for the use of goods in the pres­ent, rather than wait until the future, and those who abstained from the use of goods until the future felt the need for compensa­tion. But added to these considerations was the diminishing productivity of capital. Consequently interest rates tended to be set at a point where the payment people were willing to make for present values against future values equaled the productivity of the last unit of capital added. This was not materially different from the von Thiinen analysis except that the demand for capital was analyzed with regard to the time-preference theory. One might draw the valid conclusion that this was merely another manifestation of the process of synthesizing utility on the one hand with cost of production on the other, a relationship so fre­quently made in other theories.

Modifications of von Bohm-Bawerk, both in the sense of elaborations of and deductions from his theory, have appeared in vast quantity since his original work. General support for the theory came from such writers as the American economist Irving Fisher. Although using different approaches, even different lan­guage, the general idea of Fisher was similar to that of von Bohm-Bawerk. The interest rate was set when the marginal utility of the capital to the borrower, which consisted of both the psychological factor of time preference and the marginal productivity of the sum borrowed, was said to balance the lender's time preference and his estimate of the opportunity for investment. The general criticism leveled against this analysis was the inability to know what the psychological factors of borrowing and lending were and how they worked. Assumptions on the question could be made, but they provided a very artificial base on which to estab­lish a theory. Furthermore, the assumption that time preference led one to prefer present to future values had so many obvious ex­ceptions that it seemed unwise to believe that it applied generally or for the average man.

As opposed to the complicated analysis of von Bohm-Bawerk there was a tendency to return to simpler formulae for explaining interest and interest rates. Alfred Marshall, although he made no systematic treatment of interest, made several miscellaneous observations on the subject which may be briefly summarized.

He believed that the interest rate was set by the supply of the money stock balanced against the demand for capital. In small localities the equilibrium would remain fairly constant because supplies of capital might be drawn from outside communities. In the case of larger areas, however, the demand for capital could not be met immediately because saving required time; hence, a rise in the interest rate would be inevitable until equilibrium was re-established by the withdrawal from the market of those per­sons to whom the marginal utility of the added capital would not warrant the payment of the added cost. He indicated an accept­ance of the Say doctrine that previously invested capital did not affect the interest rate, since by no consideration could it enter the supply of money available for loans. From time to time he referred in a minor way to the time-preference idea which has led some authorities to link Marshall with von Bohm-Bawerk.

Now a note on the interest theory of John Maynard Keynes. He assumed, with some justice as far as our own society was concerned, that most people invest not because of the interest rate but because of the prospective yield or, in other words, the increase in value of the original investment. However, it was also true that a large number of persons would save even if there were no interest rate. Fundamentally the interest rates in vogue were a result of custom on the one hand and liquidity preference on the other. This line of reasoning dealt a mortal blow to classical theory, which was based, in the long run, upon supply and de­mand for capital.