Consumer Sovereignty and Interest

In Nationalökonomie, Mises finally delved into interest theory, the primary research area of his revered teacher, Böhm-Bawerk. In his classes at the University of Vienna in the 1920s, Mises had frequently dealt with contemporary interest theories. In those years, he had also planned to write a paper on the subject, but there had always been other projects that seemed more important.²⁷ In Geneva, he was finally at leisure to fill this gap.²⁸

Böhm-Bawerk had initiated the Austrian tradition of defining the phenomenon that was at issue in interest theory. He argued that the “interest rates” paid in the context of credit operations are in fact a secondary aspect of a larger phenomenon. The primary aspect of this phenomenon was given in certain price differences that could be observed on the market. The starting point for Böhm-Bawerk's theory was the common observation that successful business was characterized by a positive spread between the sum total of the prices paid for its factors of production and the sum total of prices received as proceeds for its products. Entrepreneurs earned more money by selling their products than they spent on the factors of production that brought these products into being.

This phenomenon raised the fundamental question of whether the entire spread between selling proceeds and cost expenditure can be “arbitraged away” through entrepreneurial competition, or whether at least part of this spread could never be eliminated. In other words, is there a part of it that contains a pure interest component? And if so, what is its cause?

Böhm-Bawerk's great achievement was to formulate the problem of interest theory as a value problem—a question of demonstrated preference between goods. Interest results from human choice and exchange, rather than being caused by some factor outside of human action. As the result of preference in action, interest reflects a fundamental value inequality—the choice of a more valuable alternative over a less valuable one. Observable interest rates manifest an inequality between the value of products and the total value of the corresponding means of production, including “waiting” or the “use” of capital. This way of putting the problem departed sharply from previous approaches, such as the interest theory of Carl Menger, which were based on the premise that there was a fundamental equality between these two values.²⁹ In Menger's view, interest was the value of a component part of the factors of production, whereas Böhm-Bawerk saw it as a value differential.

But where did such a value differential come from? According to Böhm-Bawerk, “Present goods have in general greater subjective value than future goods of equal quantity and quality.”³⁰ The American economist Frank Fetter later coined the term “time preference” to designate this phenomenon.³¹ It is because of a time preference for present goods over future goods that factors of production (which will yield products in the future) are less valuable than the corresponding quantity of otherwise equal products existing here and now.

Böhm-Bawerk emphasized that time preference is only the proximate cause of interest. The ultimate cause is something even more fundamental. He famously argued that time preference is itself caused by two psychological dispositions: (1) that current needs are usually less well satisfied than future needs, and (2) that human beings tend to underestimate future needs. He also argued that time preference is caused by the higher physical productivity of more roundabout methods of production—his famous “third cause” of time preference.³²

Mises rejected Böhm-Bawerk's psychological explanation of time preference. Psychology, Mises argued, could never establish that time preference was an element of the very nature of human action. In some actions, the psychological forces that Böhm-Bawerk described were at work and led to a preference of present over future goods of the same kind. But in other instances, the very opposite was the case. Böhm-Bawerk himself had admitted this point, which is why he held that time preference existed only “in general” but not in all cases of human action.³³

The Böhm-Bawerkian view of the nature of time preference had two related shortcomings. First, it was difficult to reconcile with the fact that values and prices are manifested in human choice. If choice is free, how is it that future values by their very nature—or at least “as a rule”—stand in a determinate relationship to present values? Second and more importantly, the Böhm-Bawerkian approach was in conflict with the theory of subjective value. His view of time preference concerns the value differential between homogeneous present and future goods, but the very fact that two goods exist at different points in time automatically makes them heterogeneous goods. Böhm-Bawerk himself admitted this implicitly when he emphasized that the values of present and future goods is liable to be different because they “are intended for a service of a different set of wants.”³⁴ This second point is devastating for the old time-preference theory, for one cannot even make claims with respect to present and future goods “of the same quality” without contradicting oneself.

Moreover, as can be seen from Böhm-Bawerk's equivocal description of the time preference phenomenon, which stresses that only “in general” are present goods preferred over identical future goods, he did not assert that time preference was universally positive.³⁵ In the hands of Mises's predecessors, then, time preference theory was a mere assertion that a determinate relationship between the values of future and present goods of the same kind existed. None of its champions proposed a tenable explanation for this supposed relationship other than the intuitive reference to the visible facts of the market: that the selling proceeds from products were higher than the expenditure on the corresponding factors of production. But these are the very facts to be explained by interest theory—they cannot themselves be their own explanation.

How did Mises solve these problems? He asserted on a priori grounds that time preference is at all times and places positive. Human action by its very nature involves a preference for sooner rather than later fulfillment of one's ends. Thus Mises asserted—contra Böhm-Bawerk, Fetter, and Fisher—that time preference is not the result of the psychological dispositions of man, but of the temporal nature of action. Years later, Mises nicely summarized this point in private correspondence:

Time preference is not a “psychological assumption,” but the effect of the physical and chemical structure of the universe in which man lives and acts. It refers to the fact that in order to be alive in March a man must first survive the month of February.

If the phenomenon we call time preference were not to exist, people would only consume what is subject to speedy decay. Other things they would always only save and invest as the outcome of such a behavior would in their eyes mean a greater yield than the result of investing them for a shorter period.³⁶

Mises had not so much clarified the phenomenon that his predecessors had in mind when they used the term time preference, but had instead given a complete restatement of the theory. When Böhm-Bawerk, Fetter, and Fisher used the term time preference, they referred to an observable value differential between two physically similar goods existing at two different times. But when Mises used the term, he referred to a counterfactual value differential between two alternative uses of one and the same good. Time preference concerns the value differential between a present use of a good and an alternative future use of this good that could only have been realized had a different choice been made. When I use a good now rather than later, I demonstrate that I prefer to use the good now rather than later. And this in turn necessarily means that the value of its present use is higher for me than the value of the use I might have made of it in the future.

Like Böhm-Bawerk, Mises believed that time preference was only the proximate cause of interest. But rather than seeing the ultimate cause in certain psychological dispositions of the human being, he followed Frank Fetter and Franz Cuhel in arguing that the ultimate cause was the necessity of consumption.³⁷ The fact is that human beings cannot survive if they do not consume. Hence there must be some time preference in human action or the human race would perish. This does not mean that time preference is the only factor determining human actions. It means that in order to survive, human beings must at some point prefer shorter production processes to longer ones, even though the longer ones would be more physically productive.

Mises argued that one would always choose the longest production process if one could disregard the need for survival through time.³⁸ It is the need to survive that prompts the acting person also to consider the passage of time and to prefer, at some point, sooner results to later ones.

Consider three alternative fishing processes: the first one leads to catching one fish at the end of one hour, the second to catching ten fish but only at the end of one day, and the third to catching 100 fish all of them at the end of a week. Assume we observe a person pursuing the production process leading to a catch of ten fish at the end of a day. Mises explains: the person did not pick the 100–fish alternative because his time preference was stronger than the additional gain he would have gotten from the longer process. He does not want to wait a week. The only reason he picked the ten-fish alternative at all, rather than the one-fish alternative, is that in this case the attraction of the additional gain was strong enough to overcome his time preference.

Let us highlight the significance of this explanation within the overall theoretical framework of Misesian economics. Consumption here appears as the root of all economic phenomena. Carl Menger and his disciples had argued that consumer choices directly determine the prices of consumers' goods, and that indirectly they also determine the prices of producers' goods. Now time preference, too, and with it the phenomena of capital and interest appear to be rooted in consumption. The great attraction of this explanation (at least from Mises's point of view) was that it did not stress any psychological dispositions of man, but relied on the fundamental fact that there can be no human action without consumption. The consumption-theory of time preference thus seamlessly integrates the theory of capital and interest into the general theory of prices. In the field of interest—as in the broader market process—the consumer is sovereign.