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We have written with frequency about the idea of time preferences. Specifically, we have stated that a general decrease in time preferences tends to manifest itself in lower risk taking, with the follow-on effect of asset price decreases (asset deflation), slower consumer spending (goods/service price deflation), and lower interest rates.

But why is this so? And what exactly is time preference? We have left these queries unanswered, and that was a mistake. So let's look at time preferences in a bit more detail so that we're all on the same page.

Murray Rothbard (in Man, Economy and State) states the law of time preference this way:

"Every person prefers, and will attempt to achieve, the satisfaction of a given end in the present to the satisfaction of that end in the future." (ibid pg 320)

Another way to paraphrase this is to say that, generally, men prefer things sooner rather than later and within that 'law' is an important corollary: everyone gives a different relative weight to the present and the future. What things we prefer sooner and what things later (not to mention the factors that change this very individual decision) are the essence of understanding time preference in a macro- and microeconomic sense.

Men, because we are mortal and have a finite number of time periods in our lives, naturally establish some sort of gradation between wants and needs now and wants and needs of the future. We make judgments about what to spend, what to save, what to buy, what to do, and what not to do in present time periods like today and tomorrow versus future time periods like next week, next month, next year, or 30 years from now.

Perhaps dear reader you are a 45 year old married man with three kids and a mortgage. You might have far different time preferences (preferring to save your capital now rather than consume it) than an elderly widower with no children or grandchildren. It's reasonable to expect that he would prefer present-day consumption more strongly than you, eschewing the savings bank for a trip to, say, Atlantic City.

Of course, Rothbard's law still holds for both scenarios: both you and the old man would, all things being equal, generally prefer things sooner rather than later. But all things are not equal of course; you forgo consumption now for the utility you expect to derive from future consumption. The old man, with fewer time periods left in his life, hits the baccarat table.

When time preferences decrease, men are more willing to forgo present consumption and more willing, relatively, to save their capital for some future payoff. The capital stock - the real pool of savings as Frank Shostak terms it - swells, long term investment projects increase, and interest rates decrease.

So how do decreasing time preferences affect the desire to take on risk? Well to answer that we need to understand the role that artificial credit (fiat currency) has on time preferences. Specifically, we need to understand the role that the Fed plays in creating excess credit and what impact that credit has on stimulating consumption and investment.

When the Fed creates money out of thin air by injecting liquidity into the economy, that money affects the time preferences of its beneficiaries. How? Let's use the following analogy: if you or your (lucky) family were regularly offered, say, $1000 per week every once in a while and you felt confident that you could rely on it happening with some frequency throughout the year, well, you would naturally shift your time preferences forward: you would choose to save less for the future and consume more in the present. After all, somehow $1000 just shows up without you ever having to actually do anything for it.

You say to yourself: "heck, we'll spend this $1000 on a new Weber grill and save the next $1000 check for the kids' college fund." Or variously: "I'll buy a bigger house than my salary can afford since I've got this extra income"; "let's invest in those 11% yield to maturity bonds offered by that condominium developer in California", or "aren't those Internet stocks cheap now?" The moral of the story? 'Free' money results in an increase in time preference and an increase in the desire to take on present risk.

So what happens when the excess credit created slows or reverses altogether? What happens when the reflation trade unwinds and credit contraction occurs? Well, again going to our heretofore 'lucky' family above: once the free checks stop coming in the mail, this family, realizing that their previous profligate ways are no longer sustainable, start to dig in and save, 'making up' for the spending they did in the present by saving for the future. This results in an immediate reduction in spending on, say, more accouterments for that Weber grille, or fewer steaks, or both. They look to sell their 11% condo developer junk bonds and their Internet stocks, placing the proceeds in (real or perceived) less risky investments. Time preferences decrease and a more immediate and perhaps acute sense of risk envelops this family.

So when we speak of time preference, that's what we mean. Every individual has a specific valuation of present and future wants. And that valuation can change - from family circumstances, from the passage of time (growing older), from increases or decreases in salary, from aggressive efforts by monetary authorities to "stimulate final demand." From late 2002 to 2005, we in the U.S. have increased our time preferences significantly. And the result has been an increase in risk appetite, an increase in consumption (and inflation), and remarkable decrease in saving. It is the aggregate increase or decrease in time preferences across an economy that might be especially telling right now. If indeed we are starting to see the initial signs of a decrease in time preferences - a desire to reduce risk, a desire to save and not consume, etc. - then that could have massive consequences on financial markets.

This is why we keep talking about time preferences: it's as important to understand what people are doing as it is why they are doing it.
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