Dmitry Chernikov’s Blog

Hülsmann rejects the classical Austrian account of time preference and interest and substitutes his own notions. In what follows I hope to demonstrate that he is wrong on almost every count and to vindicate the theory of interest as arising out of the market for time.

Let’s start out with the Mises’s challenge to explain why some people invest $100 to receive $104 a year later and other people don’t. What accounts for the difference in the behavior? Mises answers: time preference or preferring to be paid sooner rather than later. Hülsmann objects:

Economic comparisons are not cast in terms of physical units, but in terms of choice alternatives, and choice alternatives are always heterogeneous. In the present case, therefore, the economic comparison does not involve different multiples of the same good, but two different goods. “104 dollars in one year” are for purposes of decision-making a good that is completely different from “100 dollars now” even though from a physical point of view these might be homogeneous quantities. Therefore there is no reason to assume that 104 future dollars are inherently preferable to 100 present dollars.

I confess I find this argument strange. Does our author mean that the situations now and a year from now will be different, including the mental state of the actor and his economic environment? But Mises specifically points out that his explanation assumes “other things being equal” (Human Action, 481). When are things ever equal?, Hülsmann might counter. But we are interested in theory where we have to untangle the causes and effects; we don’t necessarily need to jump straight into the complexities of the modern economy. Thus, the only differences in the two cases are (1) $104 vs. $100 and (2) future vs. present. That $104 is always preferred to $100 follows directly from the law of diminishing marginal utility. Therefore, if $104 is not, in fact, preferred, it must needs be because the second difference plays a role: the gain lies in the future, and future money must be ranked lower on one’s value scale than present money, so much lower (for some people) that even the extra $4 is spurned in favor of the present good. Why, we shall see in a moment. But the conclusion is almost self-evident.

Hülsmann complains that time preference does not explain “why the selling proceeds exceed the expenditures for factors of production.” Of course, time is a factor of production. Rothbard makes it abundantly clear: “all actions must take place through time. Therefore time is a means that man must use to arrive at his ends. It is a means that is omnipresent in all human action. …time is always scarce, and a means to be economized.” (Man, Economy, and State with Power and Market, 5; 15) Early in the book Rothbard fails to count time as an original factor of production alongside labor and land. (10) But he corrects himself later, as is evident from: “Capital goods are vital and of crucial importance in production, but their production is, in the long run, imputable to land, labor, and time factors.” (373) “Ultimately, only land, labor, and time factors earn net incomes.” (481) And, finally, “Capital goods have no independent productive power of their own; in the last analysis they are completely reducible to labor and land, which produced them, and time. Capital goods are ’stored-up’ labor, land, and time; they are intermediate way stations on the road to the eventual attainment of the consumers’ goods into which they are transformed.” (58) There is a land market, labor market, and time market. (375)

Thus, time is a scarce factor of production; it costs money. Capital is a combination, a package of labor, land, and time; so it is a produced factor. Even natural resources have to be found which takes employment of labor over time. Land and natural resources are essential factors, because humans can’t create ex nihilo; they can only transform existing goods. Sometime a natural resource is a consumer good, e.g., a cave used as a shelter. Otherwise, either labor or time is essential to transform nature’s bounty into a consumer good. Sometimes a good will mature on its own, as wine does; other times labor takes an infinitesimal amount of time, such as driving in a nail with a nail gun. Most often, however, both labor and time are necessary.

Our author argues that time preference may indeed explain why a businessmen would in any circumstances sell his product sooner rather than later. Or receive back money lend sooner rather than later. But a lender would prefer to get his money back sooner even if the interest rate at which he lend this money was 0% or -10%. “When I lend 100 ounces of gold now to receive 90 ounces in one year, I thereby demonstrate my preference for having these 90 ounces from my debtor sooner rather than later.” In other words, it fails to explain the phenomenon of interest. How odd. Isn’t it obvious that besides the fact that 90 ounces are valued more 1 year from now than 2 years from now, there is also the fact, according to the very theory of time preference that our author claims fails to explain interest, that 90 ounces now are valued more than 90 ounces 1 year from now, and moreover and a fortiori, 100 ounces now are valued still more than 90 ounces 1 year from now? (Since now is sooner than a year from now.) Hence there can be no such thing as negative interest rates. What is left unexplained?

“The fact that we use a good right now always involves a time preference for this present use as compared to possible — but unrealized! — future uses of the same good. Hence, while time preference is an intertemporal aspect of each observed human action, in each single case it explains only the action under consideration. That is, it explains only one action. Money interest, though, as it is observed on the market results from at least two actions: purchase of means of production and sale of products; granting of credit and payment of principal and interest. The problem of interest theory is therefore to explain a particular relationship between at least two actions.” I would be hesitant to interpret Mises as saying that consumption demonstrates time preference, because all consumption by definition takes place in the present. The basic point to grasp is that waiting, like labor, is not only a full-featured factor of production but also, again like labor, has disutility. Consuming $1000 now is an opportunity cost of consuming $1500 a month later. The opportunity cost is the persistence of unsatisfied desires which are we may describe vividly as gnawing at you, eating you; a state of “uneasiness”; discomfort for a month for the sake of the extra $500. Suppose I own a microwave. It yields a constant stream of services. Thus, do you really expect me to give it you for some definite period of time without compensation, when in the meantime I’ll have to expend more effort heating my food?

If labor had no disutility or, on the contrary, brought pleasure, then things would very different than they are now; for example, workers would pay their employers for the privilege of working for them.

If you had no desires while waiting for the principal plus interest, then though time would still be a factor of production, it would be one like breathing which accompanies every act of labor, causing no concern and costing no money. For example, Hülsmann writes: “A 10-percent interest rate obtained by making steel product X, for example, does not mean that 110 ounces of gold obtained through the future sale of X are inherently more valuable than the 100 ounces paid now for the corresponding factors of production. And neither does it mean that all current investments yield in fact a 10-percent return. What it means is that there are here and now no men ready to invest 100 ounces into the production of X unless the yield is at least 110 ounces. The combined originary interests of the market participant do not allow for any arbitrage that would eradicate the minimum return of 10 percent on the production of X.” Very well, I’ll bite. Why are there no such men? What stops them from emerging? 10% return is good, isn’t it? Hülsmann throws his hands up in the air at this abject mystery and says that interest is eliminated when people pursue projects for their own sake, such that the means and the ends are one. But the time preference theory also explains why interest does not arise in such cases: because there is no waiting for the end product! Presumably, no dissatisfaction with the unavailability of the consumer good being made is felt even while and during the time the good is being created.

Similarly, Mises writes: “There is in the course of a man’s life a right moment for everything as well as a too early and too late.” (486) If I want a sandwich in 5 minutes, no earlier and no later, then the time spend waiting for the desire to eat the sandwich to arise has no disutility and is therefore is not included in the total cost of preparing a sandwich. Further, if some aspect of my future is not uncertain, for example, if I need to pay my rent in 20 days, then I can loan the money out to be returned to me on the date on which rent is due. But since I can’t risk this money on investments where I might suffer a loss, the interest rate can be almost zero, because I think of this money as though already spent, and so no disutility is attached to waiting.¹ Note that the legal difference between interest and profit in a real, not evenly rotating, economy is that loaning money at interest is not a speculative transaction but an exchange of property titles. Failure to repay the loan constitutes misappropriation and theft, whereas failure to turn a profit means only that you were a bad entrepreneur and trusted the company or mutual fund in which you invested in vain.

Hülsmann makes a distinction between what he calls interest or the difference between the prices of the means and the end; and gain or the difference between the happiness produced by satisfying the most important end and happiness that would have resulted from satisfying the (neglected) second most important end, had the means not been occupied satisfying the former. “One might take account of this fact by calling the price paid in form of forgone ends ‘praxeological price’ or just ‘price’ while calling the price paid in form of abandoned means ‘market price.’ Similarly, we may call the value of the forgone ends ‘opportunity costs’ and the value of the foregone means ‘costs’.” These definitions are confusing. Let r stand for revenue and c, for cost. Profit has to be r - c in some shape or form. So, let’s call r₁ - c₁ or the difference between means and ends “simple profit.” Further, let (r₁ - c₁) - (r₂ - c₂) be “real profit.” It is evident that simple profit is a special case of real profit, where the second r and c are negations of the first r and c. In other words, simple profit can be instantly converted into real profit if we compare it with the utility of selling the means, c₁, and forgoing the satisfaction or the end, r₁. Or: Crusoe expends labor and time which have disutility for the sake of getting food, and relieving one’s hunger is worth the effort; hence (satisfying hunger - labor) - (leisure - staying hungry) > 0, and Crusoe enjoys psychic profit.

Now all prices are relative; they allow for comparisons or ranking of an enormous variety of sets of goods, but that’s all they do; they don’t measure value. Suppose I buy a hammer and use it to build a ship and then sell the ship to the consumer and receive a monetary profit. It follows that the hammer was undervalued; and it is very similar to Crusoe’s reallocating the hammer from busting open oyster shells to building a ship in order to escape the island. He realized that he had made an error and that a more urgent goal could be achieved with the same means (namely, the hammer), and therefore greater profit realized. The difference is that Crusoe judges his own ends, whereas an entrepreneur within an economy must judge the ends of other people, the consumers, but this difference is inconsequential. For example, Crusoe is quite capable of making an entrepreneurial error, just as any person in an advanced economy: if, for example, his preferences change while he is working on his ship.

Therefore, Hülsmann’s entrepreneurial profit which he further distinguishes from interest is also real profit. It’s not “a special income component that results from errors in human decision-making.” There is nothing special about it, and it’s not an income (as only factors of production earn incomes). Moreover, for profit to be eliminated it is not necessary for other entrepreneurs to enter the relevant industry; all profit can be immediately zeroed out simply by the business owner’s paying himself a salary equal to the profits and consuming it. Anyhow, the reason why a state of equilibrium is not achieved is due to neverending entrepreneurial “creative destruction”; certainly not because there is a mystical interest income that causes an inevitable price spread between the producer goods and the consumer good.

Our author argues that his theory makes sense of why exchanges are made. For example, Smith values his apple less than Jones’s tomato, and Jones values his tomato less than Smith’s apple. And the spread, according to Hülsmann, is interest. Of course, it’s nothing of the sort; it is profit. Now every voluntary exchange yields profit for both parties. But the point is that exchanging $100 now for $100 a year from now is never profitable. And even exchanging $100 for $104 a year from now may not be profitable for some people, if the $100 now is valued more than $104 later. If it is profitable, then the revenue, namely, $4, has to be compared with the cost, namely, waiting with wishes unfulfilled, because the ownership and control of present goods are transferred for a period of time. To use neoclassical terminology, if one is indifferent between $100 and $102.50 a year from now, then the profit or “producer surplus” of the supplier of present goods is $1.50. The $2.50 is interest payment. Further, for proper understanding of exchange we must distinguish between use value and exchange value. Smith’s apple’s use value (before the exchange) is lower that Smith’s tomato’s use value (after the exchange). But the apple’s exchange value is equal to the tomato’s use value, assuming no transaction costs. In case equal values are found objectionable, let me rephrase: the apple and the tomato are no longer distinguishable as separate physical goods but become as if units of a homogeneous good, perfectly interchangeable, such as two ounces of the same lump of butter.

Hülsmann claims that his theory explains “‘negative money interest’ resulting from philanthropic undertakings.” But we need not resort to his peculiar theory to do so; the standard time preference theory of interest does it very well: the philanthropist suffers not only the loss of $10 but also the interest he could have earned on the time market, for example, by loaning the money to someone. Yet he finds the expression of his charity a greater value than even this combined loss. As Mises points out, “The businessman who owns the whole firm may sometimes efface the boundaries between business and charity. If he wants to relieve a distressed friend, delicacy of feeling may prompt him to resort to a procedure which spares the latter the embarrassment of living on alms. He gives the friend a job in his office although he does not need his help or could hire an equivalent helper at a lower salary. Then the salary granted appears formally as a part of business outlays. In fact it is the spending of a fraction of the businessman’s income. It is, from a correct point of view, consumption and not an expenditure designed to increase the firm’s profits.” (241) What’s the problem?

Even the case of the miser (490, whose consistency with time preference Mises admittedly failed to prove) is easy to explain: the miser’s satisfaction and consumption consist of contemplating his hoard rather than in spending it even on bare necessities. He prefers the loveliness of the glint of his gold coins to the food he could have bought with them.

Conclusion. Time preference explains interest which is the result of disutility of waiting with unsatisfied desires, and the spread between the cost of the means and revenue of the end, whether monetary or psychic, is not interest but profit. Basically, it seems that when Hülsmann is good, he is very good, but when he is wrong, he is horrid.

¹ The fact that I might want something at a particular time in the future, neither earlier nor later, does not refute the apodictic universality of positive time preference. The fact remains that if I have a desire, I always by necessity do not want to live with it but instead want it satisfied as soon as possible. No one wants to stay unhappy for longer than is absolutely necessary. If that desire (such as hunger) is not present though it will be present later, time preference has nothing to say about what happens in the interval between now and the desire’s emergence.