Time Passages

Well the picture is changing
You're part of a crowd
They're laughing at something
And the music's loud
--Al Stewart

A claim that has a long history, and one that seems to be getting louder, is that capitalism has a short term focus. Proponents of this viewpoint often point to the volatility observed in many modern markets as proof of a narrow time horizon.

Of course, an important assumption underlying this line of thought is that present conditions equate to capitalism--a supposition that intellectually honest individuals may have trouble establishing as true.

A basic axiom of human behavior is that individuals prefer to satisfy needs in the present rather than in the future. Therefore, we should not be surprised that people have a proclivity for 'now rather than later.' People generally value present goods higher while 'discounting' the value of future goods. Moreover, the value of future goods is likely to decrease as the length of time necessary for their completion increases.

This does not imply, however, that people always elect the short term option when making decisions. Individuals differ in their 'time preferences.' Time preference pertains to the premium individuals place on enjoyment in the present versus enjoyment in the future. Those with higher time preferences place higher value on near term enjoyment, while those with lower time preferences place more value on their future well-being.

It is also possible that individual time preferences move up and down in collective fashion. Work from the emerging field of socionomics suggests that time preference may follow social mood, cycling through phases of high time preference (perhaps during periods of collective optimism) followed by phases of low time preference (perhaps during periods of collective pessimism).

In unhampered markets, interest rates can be viewed as an expression of general time preference. High interest rates coincide with high time preference in such contexts. Those holding capital increase the price (interest rate) at which they'll lend or invest it--because they have heightened desire to consume that capital in pursuit of present day pleasures. The higher the time preference, the higher the discount (interest) rate placed on returns receivable in the future.

Conversely, low interest rates generally coincide with low time preference. Those holding capital reduce the price (interest rate) at which they'll lend or invest it--because they have little desire to consume that capital in pursuit of present day pleasures.

In free markets, interest rates provide an important signal about aggregate time preference and investment opportunity. High interest rates reflect high time preference, suggesting relatively low amounts of capital available for risky projects. Borrowing costs are high, which lowers projected return on investment, which in turn discourages speculative borrowing. On the other hand, low interest rates reflect low time preference, suggesting relatively high amounts of capital available for risky projects. Borrowing costs are low, which raises prospective returns, which in turn encourages speculative borrowing.

It appears, therefore, that free markets contain neither a long term or short term bias by nature. Instead, time horizon is likely to shift with changing time preference and the risk/reward profile offered by the cost of capital (interest rate) for risky projects. Greed (for gains) and fear (of loss) provide a natural balance for economic calculation in these changing conditions.

In hampered markets, however, the interest rate signal gets distorted, perhaps badly, by government attempts to manipulate borrowing costs. Government price fixing of interest rates (which usually amounts to keeping interest rates artificially low) can create situations that are unlikely in free, unhampered markets. For example, government can suppress interest rates during periods when aggregate time preference is high. This situation is unlikely in free markets because it cheapens borrowing costs when people are willing to take on speculative risk in order to elevate present living standards. Such conditions are unlikely to persist in free markets. Moreover, the combination of artificially cheap funds and high risk appetite is liable to spark a speculative boom grounded in high degrees of leverage.

I propose that it is this unnatural condition--the one of high leverage fueled by artificially cheap borrowing costs--that encourages the equally unnatural situation of excessively short time horizons in decision-making. We'll elaborate in a future post.