In the author's view, this conclusion is based on a rather substantial misunderstanding of the
primary text.Praxeological Time Preference and Interest:
Ludwig von Mises's Contribution to the Theory of Interest
December 12, 1997
Abstract
Mises's concept of praxeological time preference has been confused by neo-Austrians with the idea of positive time preference. Praxeological time preference refers to the idea that individuals acting in the consumer role distinguish between actions on the basis of whether they expect the effects to be felt sooner or later. Positive time preference goes beyond this to claim that some set of goods, money, or utility would always be preferred in the present to the same set in the future. Neo-Austrian economists have written as though the assumption of positive time preference is needed to explain a "positive rate of interest" in the market economy. This paper has three aims. The first is to show that Mises did not subscribe to the positive time preference view. The second is to discuss the claims to the contrary in order to show how this mistaken interpretation of Mises has evolved. The third is to present the basic assumptions that are necessary to deduce a positive rate of interest under the conditions of the pure market economy.
Outline
1. Some Terminology
2. Praxeological Time Preference and Originary Interest
3. The Evenly Rotating Economy
4. The Evenly Rotating Economy and Interest
5. Mises on Interest and Entrepreneurship in the Pure Market Economy
6. Summary of the ERE's Use to Elucidate Market Interest
7. From Praxeological Time Preference to Market Interest
8. The Trade Cycle
9. Lewin on the Evenly Rotating Economy
10. Positive Time Preference?
11. Other Misinterpretations of Mises on Time Preference
12. Conclusion
References
Ludwig von Mises's writings on time preference and interest have mainly been discussed within the relatively small circle of economists who identify themselves as Austrian. The widespread belief among these economists is that Mises subscribed to a what has been characterized as the theory of positive time preference. The typical treatment is to quote Mises once or twice and then to analyze the idea that the author assumes that Mises intended to present. This amounts to asserting an interpretation of Mises rather than defending it. Given the difficulty of comprehending Mises's major works, this is regrettable.
An exception is Peter Lewin's 1997 paper. Not only does it move the issue outside of
strictly Austrian circles, it confronts Mises head on. Lewin presents his thesis in a professional
History of Economic Thought journal. In addition, he provides longer quotes and tries to analyze
them in some depth. His assessment is not favorable to Mises. He concludes that Mises's effort to
deal abstractly with the complex problem of explaining interest was not meaningful or relevant.
In the author's view, this conclusion is based on a rather substantial misunderstanding of the
primary text.
The main aim of this paper is to show more fully how Mises used the concept of time preference to describe interest in the pure market economy. Afterwards, I try to vindicate him from Lewin's criticism.
Lewin focuses on two aspects of Mises's theory: the use of the evenly rotating economy (ERE) and time preference. Regarding the ERE, he concludes that its use is not only unnecessary but misleading. I argue that far from being unnecessary, the evenly rotating economy plays an indispensable role in the comprehension not only of interest but also of entrepreneurial profit, without which interest could not exist in the market economy. Indeed, one of Mises's distinct contributions to the history of subjectivist economic thought was to recognize and emphasize the essentiality of the ERE. Regarding time preference, Lewin claims to identify inconsistencies in Mises's discussion and he believes that one of Mises's statements about it suggests that his conception is not relevant to time preference as this term is ordinarily used. My main complaint here is that Lewin followed a number of other Austrian economists in mistakenly asserting that Mises subscribed to the positive theory of time preference. I argue instead that he merely assumed a priori that individuals take account of time in their actions. In other words, he subscribed to what is properly called praxeological time preference.
The paper begins by distinguishing between Mises's praxeological time preference and positive time preference. Part two explores the notion of praxeological time preference more deeply, connecting it to Mises's notion of originary interest. Part three defines the ERE and puts it in its proper historical context. Part four shows how Mises used the ERE to elucidate interest. Part five shows how Mises used the ERE to elucidate interest. Part six shows how Mises bridged the gap between praxeological time preference and interest in the market economy. Part seven summarizes and recapitulates the argument. Part eight shows how the elucidation of interest helped Mises present the Austrian monetary theory of the trade cycle. Part nine assesses Lewin's treatment of the ERE. Part eleven examines Lewin's claim that Mises held the theory of positive time preference. The last part traces the source of this erroneous interpretation in the Austrian economics literature. The paper ends with a brief conclusion.
1. Some Terminology
A distinction that I would like to emphasize in this paper is that between positive time preference and praxeological time preference. Lewin is concerned with the former, although he uses several terms to refer to this. First he defines time preference as follows.
...$100 today is not valued the same as $100 a year from now. They are economically different goods. In terms of the consumer's subjective preference ranking the marginal utility of $100 today is greater than the marginal utility today of $100 a year from now. This is time preference whose expression is Interest.(Lewin 1997: 144)
Next after citing a passage (discussed below) which he associates with Mises's definition of time preference, he writes that Mises "purports to prove praxeologically the necessity of positive time preference."(Lewin 147: emphasis added) Finally, he defines the theorem of time preference as the theorem "that time preference for the present must exist."(148) For Lewin the three of these seem equivalent. Time preference means the theorem of time preference, which maintains that there is positive time preference. The theorem is stated in the passage quoted above. To avoid the confusion that might arise from using these different terms, in the following discussion I use the term positive time preference to represent the theorem that Lewin claims Mises held.
As distinct from this, I shall use the term praxeological time preference to refer to the simple notion that individual preference takes account of time. This is the notion that no normal human being would (1) postpone all of his want satisfaction to the indefinite future nor (2) if he could, take all of his potential want satisfaction in the present. His preferences take account of the time at which he expects his wants to be satisfied. The next step in the paper is to describe this idea.
2. Praxeological Time Preference and Originary Interest
The fundamental assumptions that Mises makes are that actors have preferences for goods and that their actions imply praxeological time preference. The choices of acting man "regarding the removal of future uneasiness are directed by the categories of sooner and later."(Mises 1966: 483) And "[t]ime preference is a categorial requisite of human action."(ibid.: 484)
Mises demonstrates praxeological time preference in two ways. In the first, he adopts the role of the consumer-saver. He says: "He who consumes a nonperishable good instead of postponing consumption for an indefinite later moment thereby reveals a higher valuation of present satisfaction as compared with later satisfaction."(ibid.: 484). In the second, he adopts the role of the capitalist-investor of money. "Those contesting the universal validity of time preference fail to explain why a man does not always invest a sum of 100 dollars available today, although these 100 dollars would increase to 104 dollars within a year's time.(ibid.: 486, emphasis added) The fact that a "capitalist" chooses not to invest some of his money demonstrates time preference.
Time preference is manifest in the characteristic of the market economy that present goods of a given kind have a higher price than the current factors of production that are needed to produce future goods of the same kind.(ibid.: 524) We call this difference in prices originary interest. We cannot form a clear conception of it without using the evenly rotating economy (see below). Originary interest also refers to "the ratio of the value assigned to want-satisfaction in the immediate future and the value assigned to want-satisfaction in remote periods of the future...It manifests itself in the market economy [as] a ratio of commodity prices...[It is] not a price in itself."(ibid.: 526)
Originary interest is derived from, or is a different way of looking at, praxeological time preference. Accordingly, the proof of its existence is the same: if there is scarcity, there must be originary interest.
As long as the world is not transformed into a land of Cockaigne, men are faced with scarcity and must act and economize; they are forced to choose between satisfaction in nearer and in remoter periods of the future because neither for the former nor the latter can full contentment be attained.(ibid.: 528)
If praxeological time preference is such a close kin to originary interest, is it really necessary to use two terms? The only reason I can see is that the term "originary interest" seems closer to market interest. As I show later, Mises speaks of the originary interest in the evenly rotating economy as a component of market interest. However, this kind of terminology can be misleading, as I also show. Mises could have used the term time preference to refer to what I have called praxeological time preference, time preference ratio to refer to the ratio of satisfactions from near and future goods' consumption, and time preference rate to refer to the interest rate in the ERE, which corresponds to the rate of interest in the market economy. In this paper I will try to avoid the ambiguities associated with the term originary interest by referring to the time preference rate and time preference ratio. Occasionally, for further clarification, I shall also add the modifier "praxeological."
3. The Evenly Rotating Economy
In discussing the "interest problem," Mises wanted to show for the market economy how
praxeological time preference "manifests itself primarily in the interest on money."(ibid.: 538) In
the market economy, entrepreneurship takes account of consumers' preferences, including their
praxeological time preference. Accordingly, the prices of goods as well as the loan rates of
interest must have a praxeological time preference (originary interest) component. But they also
have two other components: (1) an entrepreneurial component and (2) a price premium
component.
It is convenient in this paper to disregard the price premium component. This
amounts to trying to conceive of prices and a market interest rate without the presence of
inflationary or deflationary expectations. Thus the problem is to construct an image of the market
economy in which the two components, praxeological time preference and entrepreneurship,
provide the full explanation of market interest. To solve this problem, one must make a transition
from the a priori assumption that individuals have praxeological time preference to an image of a
market economy in which there is a relationship between time preference and the market rate of
interest. Mises's solution was to utilize the image of an ERE and a refined theory of
entrepreneurship.
Constructing the image of the ERE is not a special means of elucidating interest. It is one step in the analytical procedure we must follow in order to comprehend the complex economic interaction of the pure market economy. Our eventual goal is to construct an image of the pure market economy. In the pure market economy, we assume that property rights are fully defined and enforced in all goods, that money is used as a medium in the satisfaction of all wants, that individuals are specialized, and (for good measure) that there is no fraud and no goods with public goods characteristics. Under these conditions, individuals have incentives to supply goods and services that others want in exchange for money, which they can use to purchase the goods and services that they themselves want. Only after we have constructed an image of interaction under these conditions are we prepared to construct images in which these assumptions are relaxed in various ways.
Even the interaction that occurs under the restrictive conditions of the pure market
economy is extremely complex. We must devise a means of conceptualizing the relationships we
know to exist between the markets for various goods. We know about the usual relationships
between markets for complementary and substitute goods. We know how changes in the demand
for a good usually affects prices, costs of production, and quantity. And we know how changes in
the cost of a product usually affects its price and quantity. Nevertheless, if we want to write
precisely about these "causes and effects," we need a grand framework that contains not only
these particular relationships but also their more general context. A major contribution of the
writers following the subjectivist revolution of Carl Menger was to identify functions and the
roles that individuals play in the performance of economic functions. Specifically, writers like
Bohm Bawerk and J. B. Clark showed that individuals act in the roles of consumer-savers,
suppliers of the factors of production, and entrepreneurs. To elucidate the entrepreneur role, they
first conceived of an image of a robot economy in which entrepreneurship is absent. Then they
contrasted this image with their conception of how individuals would act under the conditions of
the pure market economy. This enabled them to identify the "function" of the entrepreneur as an
appraiser of the factors, a director of the factors to their various employments, and an
uncertainty-bearer.
This, in turn, provided the grand framework they sought.
Clark (1899) called this image of a robot economy the static equilibrium, Knight (1921) called it perfect competition, Schumpeter (1934) called it the circular flow of economic life, and Mises (1966) called it the evenly rotating economy. In my view, Mises provided the least ambiguous description of it for economists. It is worth quoting at length. He said that the ERE is
a fictitious system in which the market prices of all goods and services coincide with the final prices. There are in its frame no price changes whatever; there is perfect price stability. The same market transactions are repeated again and again. The goods of the higher orders pass in the same quantities through the same stages of processing until ultimately the produced consumers' goods come into the hands of the consumers and are consumed. No changes in the market data occur. Today does not differ from yesterday and tomorrow will not differ from today. The system is in perpetual flux, but it remains always at the same spot. It revolves evenly around a fixed center.
In reality there is never such a thing as an evenly rotating economy. However, in order to analyze the problems of change in the data and of unevenly and irregularly varying movement, we must confront them with a fictitious state in which both are hypothetically eliminated...This so called static method is precisely the proper mental tool for the examination of change. There is no means of studying the complex phenomena of action other than first to abstract from change altogether, then to introduce an isolated factor provoking change, and ultimately to analyze its effects under the assumption that other things remain equal...The static method, the employment of the imaginary construction of the evenly rotating economy, is the only adequate method of analyzing the changes concerned without regard to whether they are great or small, sudden or slow...These insoluble contradictions [that change is eliminated in the ERE, that the ERE is not peopled with living men, that real action does not correspond to the ERE], however, do not affect the service which this imaginary construction renders for the only problems for whose treatment it is both appropriate and indispensable: the problem of the relation between the prices of products and those of the factors required for their production, and the implied problems of entrepreneurship and of profit and loss. In order to grasp the function of entrepreneurship and the meaning of profit and loss, we construct a system from which they are absent. This image is merely a tool for our thinking. It is not a description of a possible and realizable state of affairs. It is even out of question to carry the imaginary construction of an evenly rotating system to its ultimate logical consequences. For it is impossible to eliminate the entrepreneur from the picture of the market economy. The various complementary factors of production cannot come together spontaneously...Such a rigid system is not peopled with living men making choices liable to error; it is a world of soulless unthinking automatons; it is not a human society, it is an ant hill.(247-8)
4. The Evenly Rotating Economy and Interest
How does the ERE help us make a connection between praxeological time preference and market interest? Since the most obvious manifestation of praxeological time preference in the market economy is the choice to borrow or lend money, the rates of interest on loans in the market economy must contain, or in some way reflect, praxeological time preference. The only method we have to isolate this component from the entrepreneurial component is to use a construction like the ERE. Mises uses this method as follows. He begins by conceiving of an ERE with interest. In this ERE, interest is a return to the owners of capital goods. In the moment prior to the establishment of the equilibrium,
...the magnitude of saving and capital accumulation in the past...was adjusted to the height of the rate of interest. If...the owners of capital goods were no longer to receive any interest, the conditions which were operative in the allocation of the available stocks of goods to the satisfaction of wants in the various periods would be upset.(Mises 1966: p. 531)
Thus ERE interest exists, according to Mises, because otherwise the capital goods would be consumed and same behavior would not be repeated. Why would capital goods be consumed? "[P]recisely because there is originary interest and present want satisfaction is preferred to later satisfaction."(ibid.: 532) If there was no time preference, it would not matter whether the capital is used up.
It appears that one of Mises's purposes in trying to justify the assumption that interest exists in the ERE is to contrast his version of the ERE with Schumpeter's version, which did not contain interest. In my view, such a contrast is unnecessary and possibly distracting. It is more to the point to say that because we need an image of the ERE to help us understand the market economy, we want that image to contain some semblance of praxeological time preference. The interest rate in the ERE functions in this way. A similar line of reasoning can be applied to the relative preference for any particular good. If the ERE contained no price of apples relative to oranges, we could not use it to help us understand the price of apples relative to oranges in the market economy. An ERE that contains interest enables us to provide a rationale for the robot consumers of the ERE to spread their consumption over the imaginary repetitions of production and consumption.
I suspect that because Mises did not justify interest in this way, he went on to refer to "originary interest in the ERE." Indeed, after he had earlier defined originary interest as a subjective ratio, he later refers to the "originary rate of interest."(ibid.: 534, emphasis added) Using the term "originary" in three different contexts with three apparently different meanings is confusing. It is better to refer to (1) praxeological time preference which can be conceived in terms of (2) a praxeological time preference ratio and (3) a praxeological time preference rate. In this terminology, the interest rate in the ERE is a semblance of the praxeological time preference rate.
How then is the ERE useful if one wants to discuss time preference and interest under the conditions of the pure market economy? On the one hand, we keep in mind the interest in the ERE. On the other hand, we think of loan interest in the pure market economy. We use the image of the ERE to help us comprehend what Mises called "pure" or "net" interest in the pure market economy. We now proceed to show how Mises achieved this.
5. Mises on Interest and Entrepreneurship in the Pure Market Economy
Mises discusses entrepreneurship in relation to market interest in two sections of Human Action (1966). The first is entitled "Originary Interest in the Changing Economy." In this section, he points out that "[o]riginary interest can...in the changing economy never appear in a pure unalloyed form. It is only in the imaginary construction of the ERE that the mere passing of time matures originary interest."(ibid.: 534)
In the changing economy interest stipulated in loan contracts is always a gross magnitude out of which the pure rate of originary interest must be computed by a particular process of computation and analytical repartition.(ibid.: 535-6)
In this statement Mises uses the term "pure rate of originary interest." This seems to refer both to
interest in the ERE and to praxeological time preference, which is represented by ERE interest.
Since praxeological time preference is present in the market economy, the statement is
reasonable enough. However, the terms "pure" and "originary" can be misleading.
It would be
better to say that if we could separate out the entrepreneurial component of market interest, we
would have interest that only reflected praxeological time preference. Such a statement might
read as follows:
In the changing economy interest stipulated in loan contracts is always a gross magnitude out of which praxeological time preference could be identified if we could fully separate out the entrepreneurial component of market interest.
To show his affiliation with the subjective value theorists who employed the static
equilibrium concept in order to elucidate entrepreneurship, Mises points out that what classical
economists
called profit consisted of three conceptually distinct entities: managerial or
entrepreneurial wages (remuneration for the entrepreneur's own labor), entrepreneurial profit, and
interest. Using economic theory to separate entrepreneurial wages from entrepreneurial profit
presented little difficulty to the subjective value theorists. However, precipitating interest, the
market manifestation of praxeological time preference, did present a problem.(ibid.: 535)
..It was only the elaboration of the imaginary construction of the evenly rotating economy that made it possible to distinguish precisely between originary interest and entrepreneurial profit and loss.(ibid.: 536)
In the second discussion, entitled "The Entrepreneurial Component of the Gross Rate of Interest," Mises writes about the specific actions of entrepreneurship in relation to interest. He focuses on the transaction through which originary interest is received -- making a loan. In this transaction, the "moneylender is always an entrepreneur" because he "is always faced with the possibility that he may lose a part of the whole of the principal lent...Debtors, guarantors, and warrantors may become insolvent; collateral and mortgages may become worthless."
...Gross interest can be reaped only by creditors who have been successful in their lending. If they earn any net interest at all, it is included in a yield which contains more than merely net interest. Net interest is a magnitude which only analytical thinking [i.e., the thinking of the enlightened post-classical economist] can extract from the gross proceeds of the creditor.
The entrepreneurial component included in the creditor's gross proceeds is determined by all those factors which are operative in every entrepreneurial venture.(ibid.: 539-40)
Thus, interest contains an entrepreneurial component because every debtor, guarantor and warrantor must bear the uncertainty that the loan will not be repaid on time. We can identify the entrepreneurial component in interest only by making a contrast between the ERE and the kinds of actions that we know, by intuition, that actors would take under the conditions of the pure market economy. By the same token, it is only by means of such a contrast that we can clearly distinguish entrepreneurial profit from interest, as the citation from p. 536 of Human Action earlier in this section asserts.
Note Mises's uses the term net interest here. As before, it would be better if he simply referred to the praxeological time preference component of market interest.
Lewin appears to believe that time preference is necessarily linked to uncertainty. In italics he leads off his conclusion with “a key point.” He writes: “time preference is strongly intuitively connected to the presence and type of uncertainty in the world.” It is, of course, absolutely correct to argue that time preference in the market economy is always linked to uncertainty. The market economy is characterized by continually change in the others’ wants, abilities and knowledge. It is precisely for this reason that an evenly rotating economy is needed to separate the influence of pure time preference on action from that of uncertainty. And it is precisely this that is accomplished by the ERE construction. Thus, Lewin’s rejection of the ERE construction is consistent with his argument that time preference is linked to uncertainty. However, whereas time preference is an influence that is appropriately assigned to the role of the consumer-saver, uncertainty is an influence that is appropriate assigned to the role of the entrepreneur. What Lewin demonstrates by his linking the two together is the fudging of the entrepreneurial function.
6. Summary of the ERE's Use to Elucidate Market Interest
In considering time preference, economics is concerned with choices between goods to be consumed at different times. The fact that an individual chooses to have some amount of satisfaction in the nearest possible time period implies that he prefers that satisfaction over the later satisfaction of some alternative that he could have chosen. If it is possible to delay consumption of the consumed good until a later time, his choice indicates a preference for the present satisfaction over the future satisfaction from a good of like kind and quality. However, even if it was not possible to delay the consumption of any good, a choice to consume one good at one time instead of consuming another good at another time would reflect praxeological time preference.
Praxeological time preference is subjective. For this reason, the "time" that is referred to is subjective time. Every normal human actor knows the difference between sooner and later. However, what constitutes a late time to one person may be regarded as an early time by another. Ms. A may feel an urgent need to consume in the next moment while Mr. B may delay his consumption for several days. Yet A and B both evaluate their alternatives in terms of sooner or later. Neither is willing to postpone their satisfaction indefinitely and neither is willing to partake of all their potential lifetime satisfaction in the next instant.
Mises's treatment of the issue appears awkward. I suspect that the reason for this is that readers familiar with modern business have become accustomed to thinking of time preference in terms of rates, numerical values and signs (positive or negative). Mises does not help matters by interchanging the terms "rate" and "ratio" and by using the term originary interest in three ways: (1) in reference to praxeological time preference, (2) in reference to the rate of return on capital goods in the ERE, and (3) in reference to the "pure" or "net" interest that can be determined through analytical thinking to be a component of loan interest in the pure market economy. It is little wonder that a scholar who attempts to interpret Mises's concept gets confused.
The pieces fit together only when one realizes that to use praxeological time preference to make an inference about the rate of interest in the market economy, one must apply his knowledge about praxeological time preference for the individual to the choices entailed in market interaction. We begin by introducing the image of the ERE. We must take this step in any event in order to elucidate entrepreneurship. But it also helps us construct a conceptual bridge between time preference and loan interest. We construct the image of the ERE such that the repetitive behavior is analogous to the loan contract periods of the market economy. And we include a rate of return on capital (saving) such that it captures the concept of praxeological time preference that we know exists from our knowledge of individual choice. Because change is absent from the ERE, the rate of interest in the ERE is constant over time (i.e., over the repetitions of production and consumption). If we followed Mises, we would refer to both the ratio of praxeological time preference and the rate of interest in the ERE by using the term "originary interest." However, ERE interest is a phenomenon of a completely different kind than the praxeological time preference that we discover through the analysis of choice. It is not subjective in any meaningful sense. It is a construct of the economist's mind.
The rate of interest in the ERE is framed in such a way that it appears to correspond to
loan rates of interest in the pure market economy. However, loan rates differ from the rate in the
ERE. No lender lends all of his money repeatedly for an indefinite time. Loans in the market
economy are made for various periods of time and the contract periods of some loans overlap the
contract periods of other loans.
In addition, all of the various loan rates of interest in the market
economy include an entrepreneurial component, since the lender must bear uncertainty.
The ERE is an economy in which interest exists without entrepreneurship. In the market economy these exist together. Thus, as we shall see below, Mises seems to say that the rate of interest in the market economy has two components: ERE interest and entrepreneurial profit. However, it is obvious that the market economy cannot possess ERE interest. What he means is that the non-entrepreneurial component of interest -- the praxeological time preference component -- is conceivable only by means of analytical thinking that requires the conceptual bridge of the ERE. The proper way to express this is to say that the two components of interest in the imaginary money-neutral market economy are (1) entrepreneurial profit and (2) the return on saving that entrepreneurship makes available to individuals in their role as savers.
7. From Praxeological Time Preference to Market Interest
The existence of praxeological time preference assures that there is a return on saving. To better see this, we can contrast the market economy with the isolated actor. An isolated actor would save by either (a) setting aside goods or (b) not using all of his time and energy to produce in ways that bring him the most immediate satisfaction (without regard to the future satisfaction that is sacrificed). For example, if he had a choice to use his energy to produce either one apple for tomorrow or a million perishable oranges for today, he would save by producing the apple. The reason why he saves is that he values the future satisfaction higher than the most immediate satisfaction he can receive. We can represent his decision to save by saying that the only reason a person saves is that he expects to "earn a premium on his saving." The premium is the additional satisfaction, over what he could have today if he did not save. This premium corresponds to the praxeological time preference rate, which was described above. It corresponds to Mises's notion of originary interest for the isolated actor.
Now consider saving and interest in a market economy. An actor in the market economy
saves by using money. But what assures that the saved money will be borrowed? One might
argue that if there were no profitable uses of the money, no borrowing would occur and there
would be no interest. However, to say that there are no profitable uses of money is tantamount to
saying that individuals recognize no way to gain from producing future goods and of conserving
present durable consumers' goods for the future. In the market, the recognition of such
opportunities lies within the province of entrepreneurship. It falls under the category of
appraisement. Without appraisement, the means of satisfying consumer wants would not be
known and the assumed wants could not be satisfied. If entrepreneurs did not recognize
opportunities to gain from producing future goods (or conserving goods, if production is
somehow impossible), saving would make no sense. When the future arrived, there would be no
goods available to buy. Saving is carried out for the sole purpose of consuming future goods. In
the market economy consumer saving must accompany the presence of entrepreneurship, which
is the agency that either causes the future goods to be produced or that reserves the goods for the
consumers who demand them.
Whatever methods entrepreneurship uses to causes the goods to be available for consumers, it must borrow money. The entrepreneurial function includes borrowing the money necessary to finance the entrepreneurial action.
If follows that praxeological time preference assures that there are profitable uses for the money that is saved. It creates a demand for the money by entrepreneurs, whose function it is to see that consumers' demands for goods through time are satisfied. It thus implies a positive rate of interest in the market economy.
8. The Trade Cycle
It is helpful to realize that in focusing on praxeological time preference and interest, Mises's main goal was to present a more thorough foundation for the Austrian monetary theory of the trade cycle. The theory he presented in Human Action was based solely on the assumption that entrepreneurship tends to take account of consumer time preference. An unexpected change in the quantity of money that enters through the loan market triggers a set of false signals about praxeological time preference. As a result, consumers are less well served during this time. That this occurs is absolutely certain, given the assumptions. Rising prices and employment, followed by falling prices and unemployment, are merely one possible set of outward manifestations of the entrepreneurial errors and error-correction that must occur under the proper assumptions.
In this theory the market interest rates are not only part of the outward manifestations, they are also the signals that consumers use to indicate their praxeological time preference. When bankers or a central bank unexpectedly introduce additional currency into loan markets causing the market interest rates to fall, individuals acting as entrepreneurs erroneously regard those falling rates as a signal of a changing praxeological time preference in favor of more distant future goods. So they withdraw factors of production from near-future goods' production and allocate more factors to distant-future goods, a decision that they later regret.
Entrepreneurship is a characteristic of all individuals. Thus, the individual who decides to order a new house built because of a lower market interest rate is acting as an entrepreneur. So is the college graduate who decides to take out a loan in order to finance her graduate studies. If individuals knew in advance that the increase in quantity of money was the cause of lower rates of market interest, they would react in a different way. The trade cycle might be avoided.
This analysis concerns individuals as a group. Some individuals are faster than others at realizing their errors and, indeed, at taking advantage of the errors of their cohorts. Thus, some individuals may benefit from the ensuing trade cycle.
9. Lewin on the Evenly Rotating Economy
Lewin, while being careful to say that he does not wish to delve too deeply into this issue, nevertheless concludes that the ERE is not helpful.(155) He says that
...if the ERE does not have real time, how can we have time preference? What can it possibly mean? Without change there can be no consciousness of time. I suggest, therefore, that anything that we think that we can learn about time preference from contemplating the ERE is actually the result of a kind of subliminal modification of the assumptions to allow for real time and real choice to enter unconsciously.(Lewin 1997: 156)
In other words, he suggests that those who use the ERE to deal with time preference and interest, including Mises, have unknowingly erred in their reasoning. On the basis of the argument earlier in this paper, Lewin seems to be in error.
Let us examine what Mises says. We can begin with a statement quoted by Lewin:
Under the conditions of the market economy the rate of originary interest is, provided the assumptions involved in the imaginary construction of the evenly rotating economy are present, equal to the ratio of a definite amount of money available today and an amount available at a later date which is considered as its equivalent.(Mises 1966: 532; Lewin 1997: 154)
Now this statement appears at first to be confused. Is Mises writing about the conditions of the market economy or about the conditions of the ERE? Does or can the market economy contain an ERE? In fact with the exception of some ambiguity regard a rate and a ratio: the statement is quite clear and meaningful to one who is familiar with the task Mises was trying to accomplish and with the method of elucidation that Mises was using.
Originary interest in the statement refers to the interest in the ERE, which acts as a bridge between praxeological time preference and loan interest in the market economy. Praxeological time preference is based on the subjective perception of sooner and later, which is present in every action by definition. Interest in the ERE is a semblance of praxeological time preference which is used as a basis for understanding, by means of contrast, loan interest in the market economy.
One other point is worth noting about the statement quoted by Lewin. It seems as if Mises actually means to use the term "ratio" in referring to originary interest in the first clause. For he goes on to write of a ratio between two amounts of money.
In referring to the passage quoted above Lewin essentially argues that we are deceiving ourselves if we believe that we can learn anything about real time and time preference by studying the ERE. This statement is, of course, correct. However, our object in using the ERE is not to learn about real time or time preference but to create a bridge between praxeological time preference and its market manifestations of loan interest for agreed-upon objective time periods. One may make the argument that the ERE is unnecessary even as a bridge. But Lewin does not make this argument.
In Mises's view, the necessity of the ERE derives from its usefulness in elucidating (1)
the relationship among the prices of goods and the factors of production and (2) the
corresponding concepts of entrepreneurship and profit and loss.(ibid.: 248) In addition, he says
that the ERE enables one to distinguish entrepreneurial profit from interest.(ibid.: 536, as quoted
earlier) Surely being able to do this is an important step in using one's words meaningfully.
10. Positive Time Preference?
In part one I distinguished between praxeological time preference and positive time preference. I did this in order to construct my argument about the use of the ERE without the interference of considerations that were not relevant to the issue. It is time now to confront the question of what it means to maintain that there is positive time preference. I do not agree with Lewin's interpretation that Mises held the theorem of positive time preference as he presented it. Mises certainly assumed praxeological time preference, as defined above. In addition, he believed that the consumption of a non-perishable good indicated a preference for the good in the present over a good of like kind and quantity in the future. But this is not the same as Lewin's description of the positive theory of time preference. I first present my interpretation of Mises's argument. Then I discuss Lewin's interpretation.
In my view, Mises's argument went something like this. No one would postpone all of his
consumption to the indefinite future. Therefore every individual must exhibit time preference,
meaning that "[h]is choices regarding the removal of future uneasiness are directed by the
categories of sooner and later." (Mises 1966: 483) Moreover, a person must prefer to receive a
given amount of satisfaction in the near future to that same amount of satisfaction in the distant
future. If he was indifferent as between the two satisfactions, we would have no reason to
suppose that he would consume in the near future and, if his time preference does not change, in
the distant future either. In the absence of time preference, an individual would be willing to
postpone all his satisfaction to the future. To do this, he would have to be satiated and to live in a
land of Cockaigne.
But if he was satiated, he would not economize; we would have no reason to
discuss such a person in economics.
This seems to me to be an argument in favor of praxeological time preference but not in favor of positive time preference, as defined by Lewin. Mises asserts that individuals attach valuations to goods on the basis of when they expect to receive the satisfactions from them. However, this does not imply that they always prefer present satisfaction of one particular type to future satisfaction of the same type. I may prefer to consume an apple tomorrow rather than today because I have at my disposal today both an apple and an orange, one of which I wish to save until tomorrow. However, I would never delay my consumption of apples, oranges and all other goods indefinitely. Here I exhibit praxeological time preference but not positive time preference in terms of apples.
Mises's argument is fully consistent with a situation in which a person prefers spending,
say, $95 one year from today to $100 today. Faced with a choice between only those alternatives,
a person might well choose the $95. Of course, a person will not lend $100 for one year if the
borrower only promises to repay $95. He will, under the usual assumptions, hold on to the
money. It follows that, so long as there is only one medium of exchange, the loan rates of interest
can never be negative, even though prices may be expected to fall.
It seems unlikely that Mises would have been misinterpreted if he had presented his argument more clearly. In fact, Mises does make statements that sound like he holds the stronger thesis of positive time preference. Lewin concludes that Mises believed that he had proved "praxeologically the necessity of positive time preference" on the basis of the following quotation:
Time preference is a categorial requisite of human action. No mode of action can be thought of in which satisfaction within a nearer period of the future is not -- other things being equal -- preferred to that in a later period. The very act of gratifying a desire implies that gratification at the present instant is preferred to that at a later instant. He who consumes a nonperishable good instead of postponing consumption for an indefinite later moment thereby reveals a higher valuation of present satisfaction as compared with later satisfaction. If he were not to prefer satisfaction in the nearer period of the future to that in a remoter period, he would never consume and so satisfy wants. He would always accumulate, he would never consume and enjoy. He would not consume today, but he would not consume tomorrow either, as the morrow would confront him with the same alternative.
Not only the first step toward want-satisfaction but also any further step is guided by time preference. Once the desire a to which the scale of values assigns the rank 1 is satisfied, one must choose between the desire b to which the rank 2 is assigned and c that desire of tomorrow to which -- in the absence of time preference -- the rank 1 would have been assigned. If b is preferred to c, the choice clearly involves time preference. Purposive striving after want-satisfaction must be guided by a preference for satisfaction in the nearer future over that in a remoter future.(Mises 1966: 484; Lewin 146-7)
I examine each paragraph in turn.
In the first paragraph: the second sentence makes the apparently very strong and contestable assertion: "No mode of action can be thought of in which satisfaction within a nearer period of the future is not -- other things being equal -- preferred to that in a later period." Lifted from its context, this appears to be the theorem of positive time preference. However, since nothing else in the paragraph supports this interpretation, one ought to examine the sentence carefully. Upon closer examination, the sentence in question contains the phrase "within a nearer period." In other words, Mises seems to be referring to some nearer period. The idea Mises wants to present seems to be best captured by the third sentence. This sentence does not imply positive time preference in the usual sense. And it seems fully consistent with the second sentence
Now turn to the second paragraph. To understand what Mises is trying to show here, I believe that we must direct our attention to what Mises refers to as the "first step." The first step refers to the choice to consume in the nearer period. After taking the first step, the individual already has chosen an act that he expects to yield satisfaction in the near future over an act that he expects to yield satisfaction in the more remote future.
The paragraph quoted by Lewin is the second step. Here we begin by acknowledging the first step: a choice of a over c. Further, we assume that c would have been chosen if it were not for the fact that its satisfaction is not forthcoming until the remoter future. Then we consider the second step: a choice between c and b. b is an alternative that also yields satisfaction in the nearer future. If b is chosen over c, says Mises, "the choice clearly involves time preference." The reason is that the logic dictates that c would also be preferred to b, if c was available in the present.
Note that the choice of b over c not only indicates praxeological time preference in the sense used in this paper. It also represents the choice of an alternative which, but for its yielding satisfaction sooner, would not have been chosen over c. In this sense it indicates positive time preference. However, we should note that Mises uses the conditional term if when describing the preference of b over c. This implies that Mises regards it as possible that the individual would choose c over b.
Would the choice of c over b indicate that praxeological time preference was absent? Not if (1) a had already been chosen over c or (2) if, given that a was not available, c was preferred to some alternative in the still remoter future.
An example of the awkwardness of Mises's presentation is the following two sentences at the end of the introductory paragraph of the section from which Lewin took his quote: "...Satisfaction of a want in the nearer future is, other things equal, preferred to that in the farther distant future. Present goods are more valuable than future goods."(483) However, in the penultimate paragraph preceding this section, Mises says:
...If any role at all is played by the time element in human life, there cannot be any question of equal valuation of nearer and remoter periods of the same length. Such an equal valuation would mean that people do not care whether success is attained sooner or later. It would be tantamount to a complete elimination of the time element from the process of valuation.(483)
Mises appears to be saying that individuals cannot value the nearer periods equally with remoter periods because this would imply an indifference as to when satisfaction was felt. This is tantamount to asserting that they would not care whether they ever enjoyed the satisfaction.
It is also important to note that Mises does not include any specific time periods in this discussion. As a result, he seems to want to avoid having his argument put into a definite money form of the kind that Lewin made and which is quoted in part one of this paper. Mises says simply that a person's consumption of any good whose consumption he could postpone demonstrates positive time preference.
11. Other Misinterpretations of Mises on Time Preference
Lewin's claim that Mises held the positive theory of time preference comes at the end of a series of similar misinterpretations in the literature of Austrian economics. The confusion seems to have started with an apparently innocuous statement by Israel Kirzner about Mises's theory. After saying that Mises never published his own special study of the theory of interest, Kirzner says (among many other things):
Interest is not the specific income derived from using capital goods; nor is it 'the price paid for the services of capital.' Instead, interest expresses the universal ("categorial") phenomenon of time preference and will therefore inevitably emerge also in a pure exchange economy without production."(Kirzner 1976: 53, referring to Mises 1966: 524, 526)
So far as I know Mises did not mention a pure exchange economy. He discussed interest in the
ERE; but Kirzner cannot be referring to this, since the ERE is assumed to contain capital goods
and simulated production. In any case, Kirzner was correct to say that interest would emerge in a
pure exchange economy due to praxeological time preference.
However, since he provided no
analysis of this case, it is difficult to judge whether he appreciated the fact that entrepreneurship
and interest in a pure exchange economy could not be adequately analyzed without an image like
the ERE. Interestingly, such an image would contain no capital. Accordingly, the justification for
assuming interest given by Mises for the ERE would disappear. The only way that one could
justify the assumption of interest in a pure exchange ERE would be to say that one wishes to
build a conceptual bridge to interest in the pure exchange economy! One would have to say that
without an image of a robot pure exchange economy with simulated time preference in the form
of interest, one could not clearly separate interest from entrepreneurial profit; since he could not
elucidate entrepreneurship.
Now read how Kirzner's statement was interpreted by Laurence Moss:
According to Ludwig von Mises, this preference for earlier rather than later enjoyments in inherent in
all acts of individual choice and is termed "time preference." It has been claimed [by Kirzner] that
Misesian time preference guarantees the emergence of a positive rate of interest in a pure exchange
economy, that is, where there is no production and the economic future is known with certainty.(Moss
1976: 157)
The question here is what Moss meant by an economy in which "the economic future is known with certainty." In any case, there is again no reference to Mises's use of a pure exchange economy to illustrate interest or to the need, so evident in Mises, to use the ERE to elucidate interest.
Kirzner's characterization was repeated in a critique of Moss by Roger Garrison (1979: 149). Garrison correctly pointed out that Moss's definition of time preference in terms of neoclassical "time allocation" is an inaccurate representation of Misesian time preference, which is based on action. But also like them, he did not address the question of whether Mises had held that there would be interest in a pure exchange economy and he did not discuss the ERE.
Writing six years later about a capital-using economy, Garrison presented Mises's theory of time preference as follows:
...[M]arket participants are not indifferent about time considerations; they do have time preferences. Whether it is taken as a logical imperative or a broad generalization, there is a systematic preference for "sooner" rather than "later"; the future is systematically discounted. As a consequence, the sum of the equilibrium values of (present) inputs falls short of the anticipated value of (future) output by the extent of the time discount.(Garrision 1985: 169)
The first problem with this characterization is Garrison's statement that there is a systematic preference for "sooner" rather than "later." It would be more correct to say that praxeological time preference is a systematic preference for (1) "sometime" rather than "never" and for (2) "some later" rather than "all sooner." Garrison went on to claim that interest in equilibrium should be attributed to time preference. Is this equilibrium the same as Mises's ERE? Evidently not. If it was, one would have expected Garrison to deal with Mises's claim (described above) that without interest, the owners of the capital goods would consume their capital and the ERE could not retain its "evenly rotating" characteristic. On the other hand, if he had the ERE in mind, he would have been on solid ground in attributing interest in equilibrium to time preference. As pointed out above, the aim of having interest in the ERE is to bridge the gap between praxeological time preference and the rate of interest in the market economy. There is no evidence, however, that he saw this characteristic of the ERE as a bridge and, therefore, that he appreciated the Misesian analysis.
Most disconcerting in Garrison's essay is a footnote in which he says that "Mises...makes the case that (positive) time preference is a logical imperative."(ibid.: 185, note 10, referring to Mises 1966: 483-8) I could find no evidence of this in the cited pages.
Ingo Pellengahr complicated matters further by equating Mises's "originary rate of interest" with Wicksell's natural rate, saying that the "money interest rate converges towards the originary rate of interest."(1986: 71) Unfortunately, Pellengahr does not tell his readers what kind of economy he is writing about. If he is writing about the market economy, he cannot be correct because the money rate in the market economy always has an entrepreneurial component. And if he is writing about the ERE, the idea of convergence is not relevant since all behavior in every "time period" is repeated. In order to state the theorem properly, one must refer to the interest rate of the ERE on the one hand and the actions by the entrepreneur agency in the market economy aimed at satisfying consumers' wants through time on the other hand. Consumers' wants through time always contain praxeological time preference. Although the data of the market economy are always changing, entrepreneurship is always trying to adjust, the consequence of which is an ever-present tendency of the prices of goods and factors of production to reflect the preferences of consumers, including their time preference. Of course, outside the ERE, there are many rates of loan interest, not a single natural rate.
As a final case, we can refer to Kirzner's most recent effort. Kirzner characterized the "interest problem" as that of explaining why the price of a machine is not bid up to the point where it exactly equals the expected periodic rentals of the machine. In other words, he asks about the source of interest income.(Kirzner 1993: 167-8) Of course, the answer to this question is that there is a rate of interest in the market economy. So the next step is to ask why there is a rate of interest. Kirzner answered by referring to the "Austrian theory of interest," which he attributed to Frank Fetter and Mises. He equated the Austrian theory with the pure time preference theory. He said that this theory "solves the interest problem by appeal to the widespread (possibly universal) positive time preference." "If, in fact, people do prefer (other aspects of the situation aside) to achieve their goals sooner rather than later, then the dilemma posed by the machine and its rentals...dissolves."(171-172)
Whereas Kirzner earlier (1976) had not mentioned "positive" time preference, it here becomes a fundamental part of his explanation. He would have been more correct here if he said that the dilemma would dissolve if it was true that people would never postpone achieving all their goals indefinitely. However, to make the condition that people must prefer to achieve their goals sooner rather than later invites misinterpretation. Mises did not claim, or at least he did not literally mean, that people prefer to achieve all of their goals sooner rather than later, except in the sense that they would never postpone achieving them indefinitely.
In the 1940 German version of Human Action, Mises included a section in which he used his time preference theory to criticize Bohm Bawerk. Since he left this out of his English version, Percy Greaves decided to add it to a glossary he prepared for Mises's treatise.(Greaves 1974: 150-7) Bettina Bien Greaves translated the excerpt and Percy Greaves edited it. The critical passage is translated as follows:
...In acting, one must always, without any exception, value a satisfaction at an earlier point in time more than the same kind and amount of satisfaction at a later time. It this were not so, then it would never be possible to decide in favor of a present satisfaction. Whoever uses or consumes anything, whoever by acting to relieve to a greater or lesser extent a felt uneasiness is always expressing a preference for an earlier over a later satisfaction. Whoever eats and consumes anything is making a choice between a satisfaction in the immediate future and one in a more distant future. If he were to decide differently, if he were not to prefer the earlier to the later satisfaction, he would never be able to consume at all. He could not even eat and consume tomorrow, because when tomorrow became today, and the day after tomorrow became tomorrow, the decision to consume would still call for valuing an earlier satisfaction more than a later satisfaction. Otherwise, consumption would have to be delayed still further.(Greaves, 1974, 156-157)
I believe that this statement makes it absolutely clear what Mises meant when he said that present goods are preferred over future goods. He was referring to what I have called praxeological time preference in this paper. However, in the translation, the section in which this statement appears is entitled deceptively "All Consumers Prefer Present Goods."(ibid.: 156) Also, in a preview of the translation, Mr. and Mrs. Greaves say: "For the same reason that 'a bird in the hand is worth two in the bush,' present goods are worth more than the identical items in an uncertain future."(ibid.: 150) This is not what Mises meant. Uncertainty is a separate characteristic which Mises does not mention at all in this context.
12. Conclusion
The sole purpose of this paper has been to correct several misinterpretations of Mises's ideas. It is remarkable that during the preparation of this paper, I found no interpretations of Mises on the three issues described in the title of this paper that were both correct and penetrating enough to warrant being included. Thus the critical tone bent of this paper. Because the literature in this field has been growing rapidly, I may have missed something. Since I checked the major sources, however, whatever omission there may have been must be minor. A second remarkable aspect of the references to Mises's work is how an initially false or misleading interpretation of his time preference theory apparently became the basis for further errors. There seems to have been very little checking (or at least understanding) of primary sources. Given Mises's prominence in the so-called revival of Austrian economics, which began about twenty-five years ago, one can only hope that the rush by neo-Austrians to make their marks in this field will not obscure the lessons taught by those who are regarded as the great thinkers in its history.
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