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What is Time Preference?

June 26th, 2008

A while back, in Comments on Comments #13, The Coast responded to discussion about Allodial title. Among my charges is the argument that “governments don’t have discount rates.”

[A]s far as the government not having a discount rate isn’t quite true. The fed rate (the rate in which the loan out money to banks and I would assume other countries) is basically the discount rate and you could just take the 200 year average as a basic assumption of their future fed rate if it came down to it.

The Fed has been around for less than a century, so there is no 200-year average we could assume. But let’s not argue semantic details. The important confusion here is that the Fed’s “discount rate,” through which it engages in open market operations, is not the same as a discount rate. It is colloquially referred to as the discount rate, or the discount-window rate, and is rate at which the Federal Reserve “lends” money to its member banks (i.e., all of them).

A market interest rate, to be differentiated from the Fed Funds rate, is comprised of such a natural interest rate as accurately reflects the time preference of individuals (i.e., future goods in terms of present goods), a default premium, an inflationary expectation premium, and probably some other factor that I’m overlooking. Lenders, in order to be induced to part with their accumulated real savings for a period of time, charge interest on loans in order to compensate them for the risk of a borrower’s default, the risk of inflation wiping out their gains, and so on. But all of these components of interest can theoretically be arbitraged away.

Take note, that even if a borrower were 100% guaranteed, even if there were sound money and no threat of inflation, an interest rate would still manifest itself through the discounting of future with regards to present. Time preference can not be arbitraged away. Although the degree to which time preference manifests itself is individually unique, some degree of preference for present consumption over future consumption is axiomatic#.

The discount rate to which I refer is a time preferential discount, that is, to what degree does an individual discount the value of goods in the future, relative to the value of the same goods in the present. Even if there were no inflation, people value present consumption over future consumption, present income over future income, and present goods over future goods. The degree to which they discount the future in favor of the present is their effective discount rate, and this discount rate based on time preference guides their decision making with respect to future-oriented activity: consumption, production, leisure, etc.

At its root, interest is fundamentally the price of present goods in terms of future goods.

# Any individual proclaiming to have a negative time preference would, without hesitation, loan you all of his money today in exchange for the same sum tomorrow, at which time he would, without hesitation, loan it all to you, again. He would starve to death, always preferring to eat a meal tomorrow, rather than today.

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