Friday, January 1, 2010

Of Time and Marshmallows

As I expressed in my piece For Civilization, It Is Mises Or Bust, it seems that central banks, and the interventionist state in general, is inducing the squandering of capital at a rate that may prove fatal to civilization, and that the only way for society to avoid disintegration is for a critical mass of people to embrace the teaching of Ludwig von Mises and his students. In particular, it is imperative that as many people as possible gain as firm an understanding as possible of how central banks induce capital squandering. As Mises wrote, this is done primarily through manipulation of the rate of interest. So, to understand how the Federal Reserve and its junior partner central banks are literally destroying society, one must delve into the mystery of interest.

Time Preference and Action

The phenomenon of interest occurs because of the simple fact that, other things being equal, people prefer satisfaction sooner rather than later. This universal feature of acting man is called "time preference". Time preference can even be seen in the behavior of children, as in the seminal "marshmallow experiment" conducted at Stanford University.

From The New Yorker:

In the late nineteen- sixties, Carolyn Weisz, a four-year-old with long brown hair, was invited into a “game room” at the Bing Nursery School, on the campus of Stanford University. The room was little more than a large closet, containing a desk and a chair. Carolyn was asked to sit down in the chair and pick a treat from a tray of marshmallows, cookies, and pretzel sticks. Carolyn chose the marshmallow. Although she’s now forty-four, Carolyn still has a weakness for those air-puffed balls of corn syrup and gelatine. “I know I shouldn’t like them,” she says. “But they’re just so delicious!” A researcher then made Carolyn an offer: she could either eat one marshmallow right away or, if she was willing to wait while he stepped out for a few minutes, she could have two marshmallows when he returned. He said that if she rang a bell on the desk while he was away he would come running back, and she could eat one marshmallow but would forfeit the second. Then he left the room. (...)

Most of the children were like Craig. They struggled to resist the treat and held out for an average of less than three minutes. “A few kids ate the marshmallow right away,” Walter Mischel, the Stanford professor of psychology in charge of the experiment, remembers. “They didn’t even bother ringing the bell. Other kids would stare directly at the marshmallow and then ring the bell thirty seconds later.” About thirty per cent of the children, however, were like Carolyn. They successfully delayed gratification until the researcher returned, some fifteen minutes later. These kids wrestled with temptation but found a way to resist.

In struggling with "temptation", these children were actually deliberating over a non-interpersonal exchange: what Mises called an "autistic exchange". (Obviously the researchers would not really count as interested "parties" in the exchange.) They were deciding over an exchange concerning two differnet goods: an immediate-future good (the one treat laid out before them) in exchange for a quantitatively greater remote-future good (two treats in fifteen minutes). If speaking loosely, the former can be called a "present good", and the latter a "future good".

By virtue of their closeness in time, present goods always have a premium in relation to future goods, other things being equal; this premium is called time preference, and it varies from person to person. Another way of saying the same thing is that, by virtue of their remoteness in time, future goods always have a discount in relation to present goods, and this discount varies from person to person. Craig and the other children who did not wait exhibited a higher time preference than Carolyn and the other children who did wait. In other words, they placed a higher premium on "now", or a higher discount on "later".

Time Preference and Barter "Interest"

Time preference plays just as fundamental a role in interpersonal exchanges as it does in "autistic" exchanges. Let us imagine Craig and Carolyn as parties in a potential exchange. Craig has no marshmallows, but is expecting to get two from his mother in fifteen minutes. Carolyn has one marshmallow. They both consider the following potential exchange: Craig "borrows" Carolyn's marshmallow to eat now in exchange for "paying her back" with the two marshmallows he'll get in fifteen minutes. This potential exchange is precisely analogous to the "autistic" exchange of the Stanford experiment, except for all the additional considerations that are wrapped up in relations with others (wanting to befriend/please/not please/etc. the other person).

So, setting aside those other factors, and assuming all other things being the same as in the Stanford experiment, Craig's relatively high time preference would bring him to undertake the exchange as a borrower, and Carolyn's relatively low time preference would bring her to undertake the exchange as a lender. Craig would be willing to give up two future marshmallows in exchange for getting one present marshmallow, because, discounting for his time preference, he values the large future good less than the small present good.

And Carolyn would be willing to accept two future marshmallows in exchange for giving up one present marshmallow, because, even discounting for her time preference, she values the large future good more than the small present good.

In such an exchange, the "interest charge" would consist of the extra marshmallow Carolyn gets in exchange for waiting. As silly as it might seem to do so, there is nothing illogical about reckoning the "rate of interest" involved in this exchange as 100%, calculated over 15 minutes. (Ten "Mises points" for whoever wants to take the time to calculate the APR of this little deal.)

We can see now why interest is dependent on time preference.

Had Craig's and/or Carolyn's time preference been lower, the rate of interest would have been lower (say one present marshmallow in exchange for one and a half future marshmallows: a rate of 50%). With less urgency for immediate gratification, Craig as a borrower might have been able to hold out for a lower interest rate, and Carolyn as a lender wouldn't mind accepting such a low rate.

Had Craig's and/or Carolyn's time preferences been higher, the rate of interest might have been higher (say only one half of a present marshmallow in exchange for two future marshmallows: a rate of 150%). With a higher premium on "now", Carolyn might have insisted on a higher interest rate, and Craig might have been eager to accept it.

What would happen if Carolyn had two marshmallows instead of one? As an economic good, marshmallows obey the law of marginal utility (see this comic explaining this fundamental economic principle). As Carolyn's supply of marshmallows goes up, the utility provided by each individual marshmallow goes down. With a lower valuation for present marshmallows, she would have been willing to accept a lower interest rate. Also, according to the law of marginal utility, if Carolyne had a smaller supply of present marshmallows (say only half a marshmallow), the resulting higher marginal utility of present marshmallows would lead her to insist on a higher rate of interest.

Although it is easy to think otherwise, Craig, empty-handed as he is, has a supply of goods too! He has a supply of two future marshmallows. Future goods also are subject to the law of marginal utility. If their supply goes up, their marginal utility goes down, and vice versa. So, if Craig expected to get 3 marshmallows from his mom in 15 minutes instead of 2, this increase in his supply of future marshmallows would diminish the utility of any given amount of future marshmallows. With a lower regard for future marshmallows, he'd be willing to accept a higher interest rate. The flipside of this is that, if he expected only one marshmallow in fifteen minutes, the resulting higher marginal utility of future marshmallows would lead him to insist on a lower interest rate.

Time Preference and Money Interest

Obviously the previous hypothetical loan involved barter: a present good being offered in direct exchange for a future good. But time preference is just as fundamental to monetary exchanges and monetary rates of interest. As Mises demonstrated, present money and future money are economic goods, just as much as present marshmallows and future marshmallows are. They too are subject to the law of marginal utility, and therefore the market of present money offered against future money will behave in much the same way as the market of present marshmallows against future marshmallows. The amount of present funds in the hands of potential lenders will have an inverse relationship with its effect on the rate of interest, and the amount of future funds in the hands of borrowers will have a direct relationship with its effect on the rate of interest.

But there is one key difference. By definition, money as such is never desired for its own sake. Money is desired for its purchasing power. For example let's say Craig is in a confectionery store, and he wants a nickel in order to buy one marshmallow. (If you don't believe marshmallows could ever cost a nickel, just give the Fed a few more years.) He's flat broke, but he's getting a paltry allowance of two nickels coming to him in fifteen minutes. Let's say Carolyn is also in the store; she has a nickel, and if she were to spend it, she would spend it on buying a marshmallow too. They consider the following potential exchange: Craig borrows Carolyn's one nickel now in order to purchase and eat one marshmallow immediately after in exchange for paying Carolyn his two-nickel allowance in fifteen minutes.

The dilemma presented to the children here is highly analogous to both the dilemmas they faced with the potential barter loan of the last scenario, and the potential "autistic loan" of the Stanford experiment. Assuming analogous time preferences, Craig's relatively high time preference would impel him once again to undertake the exchange as a borrower, and Carolyn's relatively low time preference would impel her once again to undertake the exchange as a lender.

Craig would be exchanging a larger amount of future money for a smaller amount of present money, which is basically exchanging a larger degree of future marshmallow-purchasing-power for a smaller degree of present-marshmallow-purchasing power. But at bottom it is still all about the marshmallows. He's still giving up the ability to eat more marshmallows later for the ability to eat fewer marshmallows sooner.

Conversely, Carolyn would be giving up the ability to eat fewer marshmallows now for the ability to eat more marshmallows sooner. And so, given completely analogous time preferences, the five-cent loan will occur. And again, given higher time preferences, the rate of interest would be higher, and given lower time preferences, the rate of interest would be lower. (Of course, in reality money is not only desired for the sake of purchasing only a single good, but rather for the sake of purchasing a wide range of goods.)

Time Preference, Capital, and Investment Lending

Time preference is also a fundamental factor in capital investment and production. Let's say Craig and Carolyn grew up, and came to find themselves stranded on an island. Being good propertarians, they divided up the inhabitable parts of their surroundings into two separate plots, each taking one as his or her own according to who cultivated what first. Let's say there are trees on the island which bear a fibrous fruit which happens to taste just like marshmallows! In fact eating one amazingly provides the exact same experience as eating the marshmallows provided them by the Stanford researchers when they were kids. These "marshnuts" can be acquired by throwing rocks at the top of the tree. Some of the trees are taller than others, and thus their marshnuts are more difficult to reach with stones. But the taller the tree, the more abundant are their clusters; so a stone, if it can reach the top of a tall tree will knock down more marshnuts than one cast at a short tree.

Craig and Carolyn can achieve a certain low rate of productivity by throwing stones by hand at short trees. But then they both have the idea of making a sling (a capital good) out of the fibers of one of the marshnuts which can be used to cast a stone higher (They know the sling would break after one use). They'd each have to sacrifice the present satisfaction of eating the marshnut used to build the sling. But the sling would enable them to get 2 marshnuts in 15 minutes (the time it takes to construct and use the sling). This choice, between 1 present marshnut and 2 future marshnuts, ignoring the disutility of the labor involved, is precisely analogous to the Stanford experiment they underwent as children. Assuming analogous time preferences (and the severely arrested develepment implied), Craig would not make the investment, but Carolyn would.

Now let's say Craig and Carolyn find that the island is populated by an entire society of people with Peter Pan-complexes who, like Craig and Carolyn, expend most of their labor trying to get marshnuts. In spite of their childish natures, this society has managed to develop a money economy; the monetary unit is a certain beautiful seashell that can be found in the surrounding waters. The going price for marshnuts is one seashell.

After months on the island, Carolyn, with her higher time preference, races ahead of Craig in terms of wealth. She has accumulated a large capital stock of marshnut-gathering gear, as well as a large stock of saved seashells. Craig is flat broke in terms of marshnuts and clamshells. All he has are stones. He finally decides to grow up a little bit, and decides to invest in capital. He has the idea of using the fibers of two marshnuts to construct a single-use crossbow which would garner him six marshnuts. But since he's broke, the only way he can embark upon this project is by borrowing. So he approaches Carolyn for a loan. They agree to the loan exchange of two present seashell in exchange for four seashells in thirty minutes. This rate, as were the rates of the previous situations, is determined by the valuations (factoring in time preference) and levels of present and future wealth of both Craig and Carolyn. In this economy, a major factor in Carolyn's decision is the productivity of her marshnut-gathering capital goods, which determine her expected future levels of wealth, and thus the marginal utility provided to her by future marshnuts.

Craig uses his two borrowed seashells to buy two marshnuts from the local vendor, makes his crossbow, and gathers his yield. Within the half-hour, he pays Carolyn her four seashells (which he acquired by selling four marshnuts), and gets to keep two marshnuts for himself, one of which he eats. Then he has another "eureka" moment; with the fibers of eleven marshnuts, he could build a single-use catapult which would yield him forty marshnuts! So he returns to Carolyn, borrows ten seashells at a reduced interest rate of 50%, buys ten marshnuts, builds his catapult, gathers forty marshnuts, sells 15 marshnuts, pays Carolyn 15 seashells, keeps 25 marshnuts for himself, and revels in his new prosperity. Craig continues to have ideas for ever-more ambitious capital projects, and continues to borrow from Carolyn to fund them. He even comes up with capital projects which take several days to accomplish, and multiple loans to fund.

Credit Expansion and Malinvestment

Unbeknownst to Craig and Carolyn, a search party is on its way via helicopter to rescue them from their sweet-tooth neverland. Unfortunately it is headed by a fellow named "Helicopter Ben", who insists on a change of plans. Before rescuing Craig and Carolyn, he wants to rescue the island economy. From his chopper, he dumps hundreds of plaster-of-Paris fake seashells at regular intervals into the storage pits of all the lenders on the island, including Carolyn's. These "seashells" are useless for the island's "industrial purpose" for seashells, which is making necklaces, because they crumble to dust if you try to poke a hole through them (although it will take some time before the islanders come to realize this). But Helicopter Ben insists that dumping new money on the credit market ("credit expansion") will help the economy to grow.

Craig approaches Carolyn for a loan for his latest capital project: a new-and-improved catapult. But he is given pause to find that she is now only charging a bargain-basement rate of 10%! With her new abundance of seashells, the marginal utility of present seashells has plummeted for her; thus the lower rate. Craig's eyes widen. With a 10% rate, the sky's the limit for capital investment! If the 10% rate persists for a whole month, he could afford to fund his dream project: using 500 coconuts to build a giant single-use trebuchet which could reach the top of the biggest tree on the island, which would then rain down 5,000 marshnuts on the elated fellow! Would the low rate persist? "Why not?" Craig thinks, "Carolyn has been steadily lowering her rate ever since I started borrowing from her. She says it's partly because of my credit-worthiness, but also because she herself keeps getting richer from her own capital projects. Her new capital projects yield her more marshnuts, most of which she sells for more seashells. With every increase in her stock of seashells, she is more willing to accept a lower interest rate, because then each individual seashell isn't such a big deal anymore."

Craig would be perfectly right in expecting the interest rate to remain low, if it was indeed caused by an increase in Carolyn's ongoing productivity, or an increase in her savings rate due to a lowered time preference. But productivity and real savings haven't changed a whit. Helicopter Ben's plaster-of-Paris seashells haven't done anything to increase the island's wealth. The fake seashells are just media of exchange; they don't directly satisfy any human wants; nor do they produce anything that satisfies any human wants. Moreover, Helicopter Ben knows he can't keep dumping fake seashells forever. The more he dumps, the more worthless each individual seashell, fake or otherwise, becomes. If that goes on long enough, the islanders will eventually stop accepting seashells altogether, and the island will be reduced to a barter economy. So he knows at some point, he'll at least have to take a break from his seashell dumping.

Let's say Helicopter Ben decides to take a break after two weeks of dumping. With the flow of new fake seashells arrested, the marginal utility of present seashells spikes. Now that the lenders on the island regard their stocks of present seashells as more valuable than before, they are impelled to raise their interest rates. When Craig comes to Carolyn for a loan to fund his third week of trebuchet-building, he is shocked and dismayed to find that she is now charging 35%. There is no way he can afford such a steep rate for the sizes and durations of the loans he needs to finish his project. He has no other choice but abandon his precious trebuchet project. This is a huge loss, not only in time and disappoinment, but in capital too, because many of the marshnut-fiber ropes in his half-trebuchet are cut to lengths that are useless for any other kind of capital project. Those resources are totally lost. He must salvage what he can, which, as it happens, is only enough to build a meager little catapult. The basics of Craig's story are repeated dozens of times throughout the entire island economy, which is a great deal poorer thanks to Helicopter Ben's machinations. This, in simplified and fanciful form, is basically what happens every time the Federal Reserve stimulates investment by throwing new money onto the loan market. The effects of other imbalances also play out in the bust of a business cycle. But my focus in this article has been to show the reader the distorting impact that any ephemeral, artificial dip in the rate of interest will have on investment.

Higher productivity and/or increased rates of saving mean a real increase in the ongoing stream of resources available for capital investment. Such an increase make it possible to fund more ambitious capital projects. The market signal for this flow of real savings is the rate of interest. But, with its overweening power, the Federal Reserve can also lower the rate of interest through artificial bursts of credit expansion; but it can only do so temporarily, or else its monetary expansion will lead to hyperinflation, and the complete breakdown of the money economy. When interest rates drop, entrepreneurs have no reliable way to tell whether, and to what extent, the drop is caused by (A.) true increases in the ongoing flow of investable resources or by (B.) what amounts to a temporary series of one-time transfers of wealth into the loan market. With such Fed-imposed blindness to the true data of the market, businesses across the whole economy are bound to make malinvestments.

Every credit expansion must end sooner or later. And our real life Helicopter Ben, Federal Reserve Chairman Ben Bernanke is looking for his exit strategy as we speak. As soon as he executes it, all the malinvestment he has induced will be exposed to the harsh light of day, and we will come to see just how poor this Time Magazine "Man of the Year" has made us.

Bad banker. No marshmallow.

3 comments:

sonicninjakitty said...

Beautiful!

Anonymous said...

hey, how come "value-free economics and political advocacy" got pulled form lvmi's blog?
some raw nerve touched?

Hard Rain said...

Brilliant little allegory. I really enjoyed it.

And the APR for the marshmallow interest I got was 3456000%. It probably isn't right, my math sucks.

Then again I'm debt free so APR doesn't worry me very much. Only marshmallows :)