Sunday, 7 November 2010

Time Preference, Kim Kardashian, Quantitative Easing, Good Black Swan – 1 of 2

The depth, sophistication and musicality of Persian poetry is unmatched in any other language. Many of the great Iranian poets were believed in their time to have divine inspirations, so perfect is the fusion of form and content in their poems. And then there was the legendary spontaneity. A popular form of entertainment in the court or bazaar alike was throwing 4 impossibly unrelated words at a poet — toe, cow, ocean and Christ, for example — which he then used fil-bedaheh in a 4-line stanza to express an overlooked truth about life. Fil-bedaheh means on the spot, without thinking and contemplation. Such power I think had its roots in the poets’ philosophical and religious world view. If you believed that all things came from God, then all had commonalities, i.e., all were related. It was only the matter of perception of seeing the common link and the skill of putting them into a coherent whole.

The title of this post comes from that tradition, except that there is nothing fil-bedaheh about it. In fact, I made up the title after I had finished the piece, which is not quite the same thing! I, too, am a man of our time, writing in New York of 2010 where, like Ace Greenberg, everyone is looking for a little unfair advantage.

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There is, in the standard economics theory taught to all freshmen, the notion of “time preference”. According to this conjecture, “people” — that would be all people: men, women and children everywhere — prefer “now” to “then”; they’d rather have $100 now than one year later. So if they wait one year to get the money, they would demand more, say $105, for their sacrifice. That is why interest rate exists! The difference between $100 now and $105 in one year is the 5% annual interest rate.

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On Wednesay, the Federal Reserve announced phase II of its quantitative easing program (QE2), in which it will buy $600 billion of long-term U.S. government bonds over the next eight months. The idea behind QE2 is to “drive down interest rates and encourage more borrowing and growth”.

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Gotcha, Ben Shalom Bernanke! Remember your Washington Post article, published just after the announcement of QE2 to soften the critics?
Easier financial conditions [by you pushing the rates lower via QE2] will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment.
Never mind that housing shows no sign of life. What is the story about lower corporate bond rate encouraging investment? You are saying that QE2 will spur growth because it will make money available to businesses now.

But if the rates are lowered, the time preference will be destroyed. That’s what you taught in your Princeton economics course. With zero or very low interest rates, there is no incentive to act now, because the difference between then and now is zero or very little. In that case, why would corporations choose to invest now instead of say, one year from now, huh? What do you have to say to that?

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I believe in the narrowest interpretation of time preference: that in our mid to late 50s we tend to be more mature than third-graders. I know that it is not a general or inexorable law.

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Between being hanged today and next year, people would choose next year. That is also true of having a colonoscopy, getting an eviction notice, losing one’s job and life's other unpleasantries. Why, the word procrastination would not exist if people always preferred “now” to “then”. But it does, thus pointing to the hidden hedonistic supposition behind time preference: it exists only in relation with acquiring and consuming pleasurable things. The mindset that conjures up time preference, in other words, is that of a Kim Kardashian or a Paris Hilton. The economists representing that mindset take the idea and dress it up in high language and mathematical notations for respectability. Paul Samuelson, whose name pops up whenever a vacuous idea comes up, was one of the most vulgar, and therefore the most outstanding, representatives of that lot. Look at the title of his paper and then read the drivel in the abstract to see what I mean.

Beyond empty-headed women and mountebanks, what gives rise to the illusion of time preference and helps sustain and institutionalize it is the commodity fetishism of a consumer society. That is why this moon-is-made-of-green-cheese nonsense that a first-grader could refute survives. No less than the “anti-establishment” author of the Black Swan divides black swans to good and bad groups. He calls Viagra a good black swan!

Here is a link to Wikipedia on time preference. Do not limit yourself to that site. Google “time preference” and take a look at some of the results — this one, for example, written by 3 inquiring minds from the nation’s premier institutions of higher learning — to get an idea about the level of scholarship and critical thinking in 21st century America.

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There is no such thing as time preference in economics. Interest rates do not arise because humans prefer now to then. If that were the case, we would have billions of interest rates, corresponding to the subjective perception of every person on the planet. Quite the opposite: it is precisely because interest rate exists that time has “value”.

Interest is a deduction from profit. It is the share that finance capital claims from the profit of industrial capital. From Vol. 3:
When the rate of return of industrial and commercial capital falls, credit capital must likewise lower its rate. Otherwise, it would have to sit idle, having found no takers. Interest rates could indeed fall to zero and remain there for a long time if commercial or industrial capital cannot generate a profit. Under such conditions, they would have no reason to borrow, as borrowing would only aggravate the loss. In that regard, the Federal Reserve in the U.S. that raises and lowers interest rates to “cool down” or “stimulate” the “economy” merely reacts to market condition rather than shapes it.
These lines were written more than 5 years ago. What are the conditions now?

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The industrial capital in the West has migrated to the East and South in search of lower labor costs and higher profits. (Capital has migrated, not its owners.)

Alas, the investment opportunities in the East and South cannot accommodate all the mass of ready-to-be-employed capital. So, a portion of capital in the West is left behind, sitting idle with no place to go.

That cannot go on. It cannot be allowed.

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One way of generating employment opportunities for the idle capital is lowering labor costs in the West. If you are reading this in the Western hemisphere, everything you read in your local newspaper about economics and “politics” revolves around this issue. Cameron, Sarkozy, Papandreou, Zapatero, Cowen, Dombrovskis, even Merkel have no higher priorities. I have written about this issue. See, for example, here and here.

This idleness has a physical manifestation as well, but its most telling sign is the large pile of cash that corporations have amassed on their balance sheet.

Economics-professor-turned-the-Fed-chairman does not understand this process; at best he understands it superficially. He is trying to revive the activities of industrial capital by lowering the rates, fancying that with rates at zero or close to zero, the prospect of even low profit rate like 2% will induce corporations to borrow and invest. But the process is not reversible. Corporations cannot be induced to making investment – no matter how low the interest rates – if their investments would not generate income. That is why they have large spare, i.e., unused, capacity. Bernanke absent-mindedly admits that much when he writes that “low and falling inflation indicate that the economy has considerable spare capacity”. When corporations do not use the money they already have – because they cannot – what would they do with more money?

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Corporations sitting on a large pile of cash which they cannot invest buy other corporations to benefit from “synergy”. That is the polite word for layoffs – hardly the stuff of economic recovery.

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If QE2 will not influence investment decisions and economic recovery, what will it do?