Time for a change of thinking

Why is it that certain people can never get ahead?  Why is it that certain groups of people can never lift themselves from a position of being an employee to being an employer?

To find the answer we need to understand time preference.

Wait for it...

As acting humans using means to obtain ends, we prefer attaining those ends sooner rather than later.  If someone has the option of investing R100 in two lines of production, one returning a total of 10% over six months and the other returning a cumulative 10% over two years, he/she will prefer to invest in the line where the return of R110 will be returned in the shortest space of time, i.e. six months.  Here we leave out the issue of psychic revenues.  In other words, we assume he/she is indifferent between investing in the production of clothing made of animal fur or synthetic materials, for example (just for the purposes of illustration).

This is what we call time preference, and it is always positive sloping in economic action. When people strive to attain certain ends, they always prefer to attain those ends sooner rather than later.

I will always prefer receiving and controlling R100 today rather than receiving and controlling R100 a year from now.  However, I might prefer receiving R120 in a year from now to receiving R100 today.  For illustrative purposes, we assume a stable purchasing power of the currency – no inflation or deflation.

Here, in order to give up R100 today you will need to be compensated with a return of R20 plus your initial capital of R100.  This is the rate of interest you will require to part with R100 today – your time preference.

For interest’s sake, what rate of interest would entice you, dear reader, to give up R1000 today to be returned to you in a year’s time?  By dropping an anonymous comment below it may make for an interesting HA poll.  What would be the rate for your wife/husband, your employer, your best friend?

Having given this some thought, it is easy to see that no two people’s time preferences are exactly the same, and only on the market, where these transactions take place, can we establish what the market rate of interest really is.  Your time preference may be lower for R10 than it is for R10,000.  There is an infinity of factors that determine your personal time preference, an important one being the amount of savings you have available at a particular time.  Time preferences can change on a day-to-day basis, it is never fixed for any prolonged period of time.

Just like me or you cannot know what the market rate of interest is or will be tomorrow, no central bank in the world can know it either.  In fact, all central banks around the world believe they can force a lowered time preference upon the market in the absence of increased savings to encourage spending.

It is a recipe for total disaster, but this is a topic for another day.  Time preference is the importance one places on the consumption of present goods over future goods.  The R100 you give up today is a present good.  Rather than lend or invest it into the time market, you can exchange it for something and consume it today.  A R100 note you invest or lend to someone else means you do not have immediate access to it, and it has become a future good to you.

The crux of the matter of poverty and wealth creation is that in order to create wealth, an individual must accumulate capital.  In order to accumulate capital, he must save and invest.  Investment is not restricted to the stock exchange, and focussing on shares, real estate, and unit trusts is in fact a very narrow definition of the term.  Investment means transforming your labour and some commodities into a final good.  Savings and investment are two very closely related terms.  You must save (not consume 100% of your income) if you are to invest (mould factors into a product).

This is where time preference again comes in.

Those who hold a lower time preference, and are willing to save and invest a portion of their incomes are able, through a continuous process of saving and investment, to accumulate wealth.  This is true whether you earn R1,000 per month or R100,000 per month.

Now it is true that a relatively poorer person living on R1,000 has less present goods at his disposal for saving and investment, but it does not detract from the fact that he is able, by consistently consuming less than he produces, to accumulate capital and wealth.  Arguing that someone cannot become wealthy on a subsistence salary is a fallacy because it would imply that the entire world must still be poor, as cavemen did not receive a monetary income.  One does not require a monetary income to accumulate capital or become wealthy.

A person who consumes his entire income of R100,000 per month, by spending on lavish meals, buying international fashion labels, and German household appliances, can consume vast amounts of present goods, while never accumulating capital or wealth.  Remove his income, and he has a pile of depreciating assets and consumables, some more durable than others.

The time preference of those groups of people who consume 100% of their incomes or more – by going into debt to consume – is significantly higher than those who do not.

Capital accumulation and wealth creation ultimately takes place in a society where individuals have low time preferences and prefer to consume less than they produce, and to allocate those savings into avenues that will lead to increased production and goods in the future.  It is a society where individuals choose to have at their disposal some future goods rather than none.

Governments and their central banks today have observed the general conditions that have brought about prosperity in the past – an environment of low time preferences – and are mimicking free market economic conditions of low time preferences by controlling the money supply and forcing interest rates lower by flooding the market with newly created currency.  As you can see, while it can change interest rates on the loanable funds market (price of loans/borrowing costs), it cannot change individual and collective time preferences, and while it is not self-evident today, continuing down this path will lead to massive overconsumption at the expense of real saving and investment, and ultimately lead to empoverishment of all.