We concluded the last chapter by explaining how economic agents use the most salable good, i.e. money to stave off future uncertainty. We also explained that the sequential nature of temporal phenomena leads us to fight uncertainty gradually: only when we know that our subsistence will be assured for the next week can we concentrate toward goals farther into the future.

Or, to say it differently: as human beings we discount the value of future goods.

This subjective evaluation of the value of future goods compared to present goods is referred to as time preference. All else being equal, present goods are inherently preferred over future goods. Since we are mortal, and the future is always uncertain, we naturally prefer to have access to a good now rather than later. While time preference can differ between individuals, due to a myriad of factors such as culture, wealth, education, physiology, etc., time preferences are always positive, meaning that all things equal, we always value present goods more than future goods.

This concept of relative valuation of future goods over present goods is at the root of the phenomenon of interest. Indeed, in an economy with unmanipulated capital markets, reference interest rates (considered risk-free from default) are determined at the intersection of capital supply and demand. Therefore, these rates represent the state of time preferences for the entire economy: an increase in the interest rate results from a relative increase in demand for capital compared to supply, indicating higher time preferences. Conversely, a decrease in interest rates occurs due to an increase in savings, which is an increase in the supply of capital, indicating a reduction in time preferences.

In an economy where interest rates are not manipulated by the central bank, we tend to observe an upward-sloping yield curve: the longer the maturity of the debt, the higher the interest rate. The opposite situation can’t happen because it would entail that the future is more certain than the present, which is a logical impossibility.

The concept of time preference and how we express our own time preference by act of consumption and savings is fundamental to the processes of capital allocation and production. Let’s turn to Menger’s student, Eugen von Böhm-Bawerk, and his capital theory to understand exactly how time preference affect the organization of production.

At the beginning of this course, we saw that, for Carl Menger, goods are only considered economic goods (valued) because they serve as means to ends chosen and valued by individuals. According to this view, all economic analysis revolves around consumption because it is ultimately the motivating objective behind all economic activity. Therefore, for Menger, the starting point of economic analysis is consumer goods, or final goods, as they represent the ultimate purpose of economic activity. All other goods in the economy, which we can call "intermediate goods," only have value because they enable individuals to obtain these consumer goods: they are goods used in the production of other goods.

To produce consumer goods, entrepreneurs combine these various intermediate goods with original factors of production (labor, land, and capital) according to a pattern that maximizes the resulting production. This arrangement, made by entrepreneurs, or the production structure, includes various stages during which intermediate goods undergo transformations until they eventually become consumer goods.

Thus, like Menger, we can define consumer goods as first-order goods, goods involved in the previous stage as second-order goods, those in the stage before that as third-order goods, and so on, until we reach the original factors (land, labor, capital). The number of stages we consider fundamentally depends on the production structure adopted by entrepreneurs and should not be seen as an objective characteristic of the production structure. On the contrary, production stages and intermediate goods only exist within a teleological context: the actor envisions a sequence of actions through which they will achieve their desired objective, and they mentally divide their action into successive stages.

This characteristic of mental projection of action in a sequential pattern is imposed by the temporal nature of human action. Each action undertaken by humans takes time; immediate action is impossible. Therefore, the actor always has a choice among action patterns that take more or less time.

Henceforth, since individuals necessarily have positive time preferences, meaning they prefer present goods to future goods, they will only choose a longer path if the result obtained has greater subjective value for them than what they would have achieved by taking the direct path. Otherwise, no one would adopt more time-consuming methods: under equivalent results, the shortest path remains the preferred choice.

Due to the sequential nature of human action, these intertemporal choices always have implications for the action sequence. In other words, the short-term actions I take are subordinate to the long-term goals I set, and my short-term actions will influence what I can do in the future. The implication of this obvious point concerning production activities is that any production detour, i.e., any lengthening of the production structure, requires prior saving. If I decide to allocate more resources in the present to achieve a future goal, I must first set aside what will sustain me during the time my investment takes.

To illustrate this point, let's revisit the example given by Böhm-Bawerk, in his work "Capital and Interest":

Eugen von Böhm-Bawerk (1851-1914)

Robinson Crusoe Landing Stores from the Wreck, John Alexander Gilfillan (1793-1864)

In his book, the Austrian economist invites us to consider the intertemporal trade-offs inherent in production detours through a thought experiment based on Robinson Crusoe alone on his island.

Robinson, like a primitive human, depends on foraging and hunting for his sustenance. Let's imagine that Robinson can gather enough berries to feed himself for a whole day in eight hours. In such conditions, he has little time for other activities. However, Robinson believes that by making a wooden pole, he could easily knock down the berries and obtain his daily food in just four hours of work. Furthermore, he estimates that it will take him five days, working two hours each day, to make the pole. Therefore, he concludes that he needs to save 1/5th of his berry production for five days, or alternatively spend an additional 2 hours per day on gathering for 5 days, to save enough berries to sustain himself during the time he spends making the pole.

If he doesn't make this prior saving, Robinson will be unable to complete his pole and might die in the meantime.

So, for five days, he sacrifices two hours of his rest to gather more berries. At the end of this period, he has enough berries and begins crafting the wooden pole, working two hours a day for five days. Once his work is done, he can obtain enough berries for his daily portion in 4 hours instead of 8, allowing him to use the remaining 4 hours a day for other activities.

By acting this way, Robinson takes a production detour: instead of directly gathering the berries, he invests effort in producing a capital good that will make him more productive in the future. However, he must make a short-term sacrifice, i.e., save, to achieve this. If he didn't, he would be unable to complete his capital good. This short-term sacrifice, however, provides him with a significant advantage since, once equipped with his pole, he gains 4 hours per day (until the pole becomes obsolete). These 4 extra hours per day enable him to create more capital goods, such as hunting tools or fishing nets, gradually improving his situation.

In other words, in Robinson Crusoe's one-person economy, saving through the sacrifice of present satisfaction is what accumulates the capital that increases productivity. In this context, saving, i.e., deferring present satisfaction, is the price to pay for increased future satisfaction. This means that, in this context, saving is the prerequisite and necessary condition for any economic development.

This is a tantalizing, albeit simple, concept: any extension of the production structure requires prior savings (as the goods needed for such production won’t fall from the sky), and thus, the more we save, the more capital we will be able to accumulate, which will in turn translate into productivity gains yielding more goods. Thus, Austrian economists consider that the lowering of time preferences is the starting point for a virtuous cycle of savings –> more capital goods  more productivity  more goods = higher standard of living –> lower time preference.

Now, as eluded in the first chapter, interest rates have been manipulated for decades by central banks all the while commercial banks extended credit without prior reserves, meaning that interest rates don’t represent our time preference and gives an illusion of abundant savings.

This is perfectly illustrated by the chart below: long-rates are lower than short-rates. First, this makes absolutely no sense, because it would entail that the future is more certain than the present. Second, it warrants an inquiry about the consequences for capital allocation: if everyone is incentivized to act as if savings were abundant, whereas savers are nowhere to be found because they are not rewarded for saving, what consequences could this yield for the economy?

This is what we will find out in the next chapter dedicated to the Austrian Theory of the Business Cycle!