One defence of interest is the notion of the "time value" of money, that individuals have different "time preferences." Most individuals prefer, it is claimed, to consume now rather than later while a few prefer to save now on the condition that they can consume more later. Interest, therefore, is the payment that encourages people to defer consumption and so is dependent upon the subjective evaluations of individuals. It is, in effect, an exchange over time and so surplus value is generated by the exchange of present goods for future goods.
Based on this argument, many supporters of capitalism claim that it is legitimate for the person who provided the capital to get back more than they put in, because of the "time value of money." This is because investment requires savings and the person who provides those had to postpone a certain amount of current consumption and only agree to do this only if they get an increased amount later (i.e. a portion, over time, of the increased output that their saving makes possible). This plays a key role in the economy as it provide the funds from which investment can take place and the economy grow.
In this theory, interest rates are based upon this "time value" of money and the argument is rooted in the idea that individuals have different "time preferences." Some economic schools, like the Austrian school, argue that the actions by banks and states to artificially lower interest rates (by, for example, creating credit or printing money) create the business cycle as this distorts the information about people's willingness to consume now rather than later leading to over investment and so to a slump.
That the idea of doing nothing (i.e. not consuming) can be considered as productive says a lot about capitalist theory. However, this is beside the point as the argument is riddled with assumptions and, moreover, ignores key problems with the notion that savings always lead to investment.
The fundamental weakness of the theory of time preference must be that it is simply an unrealistic theory and does not reflect where the supply of capital does come from. It may be appropriate to the decisions of households between saving and consumption, but the main source of new capital is previous profit under capitalism. The motivation of making profits is not the provision of future means of consumption, it is profits for their own sake. The nature of capitalism requires profits to be accumulated into capital for if capitalists did only consume the system would break down. While from the point of view of the mainstream economics such profit-making for its own sake is irrational in reality it is imposed on the capitalist by capitalist competition. It is only by constantly investing, by introducing new technology, work practices and products, can the capitalists keep their capital (and income) intact. Thus the motivation of capitalists to invest is imposed on them by the capitalist system, not by subjective evaluations between consuming more later rather than now.
Ignoring this issue and looking at the household savings, the theory still raises questions. The most obvious problem is that an individual's psychology is conditioned by the social situation they find themselves in. Ones "time preference" is determined by ones social position. If one has more than enough money for current needs, one can more easily "discount" the future (for example, workers will value the future product of their labour less than their current wages simply because without those wages there will be no future). We will discuss this issue in more detail later and will not do so here (see section C.2.7).
The second thing to ask is why should the supply price of waiting be assumed to be positive? If the interest rate simply reflects the subjective evaluations of individuals then, surely, it could be negative or zero. Deferred gratification is as plausible a psychological phenomenon as the overvaluation of present satisfactions, while uncertainty is as likely to produce immediate consumption as it is to produce provision for the future (saving). Thus Joan Robinson:
"The rate of interest (excess of repayment over original loan) would settle at the level which equated supply and demand for loans. Whether it was positive or negative would depend upon whether spendthrifts or prudent family men happened to predominate in the community. There is no a priori presumption in favour of a positive rate. Thus, the rate of interest cannot be account for as the 'cost of waiting.'
"The reason why there is always a demand for loans at a positive rate of interest, in an economy where there is property in the means of production and means of production are scarce, is that finance expended now can be used to employ labour in productive processes which will yield a surplus in the future over costs of production. Interest is positive because profits are positive (though at the same time the cost and difficulty of obtaining finance play a part in keeping productive equipment scarce, and so contribute to maintaining the level of profits)." [Contributions to Modern Economics, p. 83]
It is only because money provides the authority to allocate resources and exploit wage labour that money now is more valuable ("we know that mere saving itself brings in nothing, so long as the pence saved are not used to exploit." [Kropotkin, The Conquest of Bread, p. 59]). The capitalist does not supply "time" (as the "time value" theory argues), the loan provides authority/power and so the interest rate does not reflect "time preference" but rather the utility of the loan to capitalists, i.e. whether it can be used to successfully exploit labour. If the expectations of profits by capitalists are low (as in, say, during a depression), loans would not be desired no matter how low the interest rate became. As such, the interest rate is shaped by the general profit level and so be independent of the "time preference" of individuals.
Then there is the problem of circularity. In any real economy, interest rates obviously shape people's saving decisions. This means that an individual's "time preference" is shaped by the thing it is meant to explain:
"But there may be some savers who have the psychology required by the text books and weigh a preference for present spending against an increment of income (interest, dividends and capital gains) to be had from an increment of wealth. But what then? Each individual goes on saving or dis-saving till the point where his individual subjective rate of discount is equal to the market rate of interest. There has to be a market rate of interest for him to compare his rate of discount to." [Joan Robinson, Op. Cit., pp. 11-12]
Looking at the individuals whose subjective evaluations allegedly determine the interest rate, there is the critical question of motivation. Looking at lenders, do they really charge interest because they would rather spend more money later than now? Hardly, their motivation is far more complicated than that. It is doubtful that many people actually sit down and work out how much their money is going to be "worth" to them a year or more from now. Even if they did, the fact is that they really have no idea how much it will be worth. The future is unknown and uncertain and, consequently, it is implausible that "time preference" plays the determining role in the decision making process.
In most economies, particularly capitalism, the saver and lender are rarely the same person. People save and the banks use it to loan it to others. The banks do not do this because they have a low "time preference" but because they want to make profits. They are a business and make their money by charging more interest on loans than they give on savings. Time preference does not enter into it, particularly as, to maximise profits, banks loan out more (on credit) than they have in savings and, consequently, make the actual interest rate totally independent of the rate "time preference" would (in theory) produce.
Given that it would be extremely difficult, indeed impossible, to stop banks acting in this way, we can conclude that even if "time preference" were true, it would be of little use in the real world. This, ironically, is recognised by the same free market capitalist economists who advocate a "time preference" perspective on interest. Usually associated with the "Austrian" school, they argue that banks should have 100% reserves (i.e. they loan out only what they have in savings, backed by gold). This implicitly admits that the interest rate does not reflect "time preference" but rather the activities (such as credit creation) of banks (not to mention other companies who extend business credit to consumers). As we discuss in section C.8, this is not due to state meddling with the money supply or the rate of interest but rather the way capitalism works.
Moreover, as the banking industry is marked, like any industry, by oligopolistic competition, the big banks will be able to add a mark up on services, so distorting any interest rates set even further from any abstract "time preference" that exists. Therefore, the structure of that market will have a significant effect on the interest rate. Someone in the same circumstances with the same "time preference" will get radically different interest rates depending on the "degree of monopoly" of the banking sector (see section C.5 for "degree of monopoly"). An economy with a multitude of small banks, implying low barriers of entry, will have different interest rates than one with a few big firms implying high barriers (if banks are forced to have 100% gold reserves, as desired by many "free market" capitalists, then these barriers may be even higher). As such, it is highly unlikely that "time preference" rather than market power is a more significant factor in determining interest rates in any real economy. Unless, of course, the rather implausible claim is made that the interest rate would be the same no matter how competitive the banking market was — which, of course, is what the "time preference" argument does imply.
Nor is "time preference" that useful when we look at the saver. People save money for a variety of motives, few (if any) of which have anything to do with "time preference." A common motive is, unsurprisingly, uncertainty about the future. Thus people put money into savings accounts to cover possible mishaps and unexpected developments (as in "saving for a rainy day"). Indeed, in an uncertain world future money may be its own reward for immediate consumption is often a risky thing to do as it reduces the ability to consumer in the future (for example, workers facing unemployment in the future could value the same amount of money more then than now). Given that the future is uncertain, many save precisely for precautionary reasons and increasing current consumption is viewed as a disutility as it is risky behaviour. Another common reason would be to save because they do not have enough money to buy what they want now. This is particularly the case with working class families who face stagnating or falling income or face financial difficulties.[Henwood, Wall Street, p. 65] Again, "time preference" does not come into it as economic necessity forces the borrowers to consume more now in order to be around in the future.
Therefore, money lending is, for the poor person, not a choice between more consumption now/less later and less consumption now/more later. If there is no consumption now, there will not be any later. So not everybody saves money because they want to be able to spend more at a future date. As for borrowing, the real reason for it is necessity produced by the circumstances people find themselves in. As for the lender, their role is based on generating a current and future income stream, like any business. So if "time preference" seems unlikely for the lender, it seems even more unlikely for the borrower or saver. Thus, while there is an element of time involved in decisions to save, lend and borrow, it would be wrong to see interest as the consequence of "time preference." Most people do not think in terms of it and, therefore, predicting their behaviour using it would be silly.
At the root of the matter is that for the vast majority of cases in a capitalist economy, an individual's "time preference" is determined by their social circumstances, the institutions which exist, uncertainty and a host of other factors. As inequality drives "time preference," there is no reason to explain interest rates by the latter rather than the former. Unless, of course, you are seeking to rationalise and justify the rich getting richer. Ultimately, interest is an expression of inequality, not exchange:
"If there is chicanery afoot in calling 'money now' a different good than 'money later,' it is by no means harmless, for the intended effect is to subsume money lending under the normative rubric of exchange . . . [but] there are obvious differences . . . [for in normal commodity exchange] both parties have something [while in loaning] he has something you don't . . . [so] inequality dominates the relationship. He has more than you have now, and he will get back more than he gives." [Schweickart, Against Capitalism, p. 23]
While the theory is less than ideal, the practice is little better. Interest rates have numerous perverse influences in any real economy. In neo-classical and related economics, saving does not have a negative impact on the economy as it is argued that non-consumed income must be invested. While this could be the case when capitalism was young, when the owners of firms ploughed their profits back into them, as financial institutions grew this became less so. Saving and investment became different activities, governed by the rate of interest. If the supply of savings increased, the interest rate would drop and capitalists would invest more. If the demand for loans increased, then the interest rate would rise, causing more savings to occur.
While the model is simple and elegant, it does have its flaws. These are first analysed by Keynes during the Great Depression of the 1930s, a depression which the neo-classical model said was impossible.
For example, rather than bring investment into line with savings, a higher interest can cause savings to fall as "[h]ousehold saving, of course, is mainly saving up to spend later, and . . . it is likely to respond the wrong way. A higher rate of return means that 'less' saving is necessary to get a given pension or whatever." [Robinson, Op. Cit., p. 11] Similarly, higher interest rates need not lead to higher investment as higher interest payments can dampen profits as both consumers and industrial capitalists have to divert more of their finances away from real spending and towards debt services. The former causes a drop in demand for products while the latter leaves less for investing.
As argued by Keynes, the impact of saving is not as positive as some like to claim. Any economy is a network, where decisions affect everyone. In a nutshell, the standard model fails to take into account changes of income that result from decisions to invest and save (see Michael Stewart's Keynes and After for a good, if basic, introduction). This meant that if some people do not consume now, demand falls for certain goods, production is turned away from consumption goods, and this has an effect on all. Some firms will find their sales failing and may go under, causing rising unemployment. Or, to put it slightly differently, aggregate demand — and so aggregate supply — is changed when some people postpone consumption, and this affects others. The decrease in the demand for consumer goods affects the producers of these goods. With less income, the producers would reduce their expenditure and this would have repercussions on other people's incomes. In such circumstances, it is unlikely that capitalists would be seeking to invest and so rising savings would result in falling investment in spite of falling interest rates. In an uncertain world, investment will only be done if capitalists think that they will end up with more money than they started with and this is unlikely to happen when faced with falling demand.
Whether rising interest rates do cause a crisis is dependent on the the strength of the economy. During a strong expansion, a modest rise in interest rates may be outweighed by rising wages and profits. During a crisis, falling rates will not counteract the general economic despair. Keynes aimed to save capitalism from itself and urged state intervention to counteract the problems associated with free market capitalism. As we discuss in section C.8.1, this ultimately failed partly due to the mainstream economics gutting Keynes' work of key concepts which were incompatible with it, partly due to Keynes' own incomplete escape from neoclassical economics, partly due the unwillingness of rentiers to agree to their own euthanasia but mostly because capitalism is inherently unstable due to the hierarchical (and so oppressive and exploitative) organisation of production.
Which raises the question of whether someone who saves deserve a reward for so doing? Simply put, no. Why? Because the act of saving is no more an act of production than is purchasing a commodity (most investment comes from retained profits and so the analogy is valid). Clearly the reward for purchasing a commodity is that commodity. By analogy, the reward for saving should be not interest but one's savings — the ability to consume at a later stage. Particularly as the effects of interest rates and savings can have such negative impacts on the rest of the economy. It seems strange, to say the least, to reward people for helping do so. Why should someone be rewarded for a decision which may cause companies to go bust, so reducing the available means of production as reduced demand results in job loses and idle factories? Moreover, this problem "becomes ever more acute the richer or more inegalitarian the society becomes, since wealthy people tend to save more than poor people." [Schweickart, After Capitalism, p. 43]
Supporters of capitalists assume that people will not save unless promised the ability to consume more at a later stage, yet close examination of this argument reveals its absurdity. People in many different economic systems save in order to consume later, but only in capitalism is it assumed that they need a reward for it beyond the reward of having those savings available for consumption later. The peasant farmer "defers consumption" in order to have grain to plant next year, even the squirrel "defers consumption" of nuts in order to have a stock through winter. Neither expects to see their stores increase in size over time. Therefore, saving is rewarded by saving, as consuming is rewarded by consuming. In fact, the capitalist "explanation" for interest has all the hallmarks of apologetics. It is merely an attempt to justify an activity without careful analysing it.
To be sure, there is an economic truth underlying this argument for justifying interest, but the formulation by supporters of capitalism is inaccurate and unfortunate. There is a sense in which 'waiting' is a condition for capital increase, though not for capital per se. Any society which wishes to increase its stock of capital goods may have to postpone some gratification. Workplaces and resources turned over to producing capital goods cannot be used to produce consumer items, after all. How that is organised differs from society to society. So, like most capitalist economics there is a grain of truth in it but this grain of truth is used to grow a forest of half-truths and confusion.
As such, this notion of "waiting" only makes sense in a 'Robinson Crusoe" style situation, not in any form of real economy. In a real economy, we do not need to "wait" for our consumption goods until investment is complete since the division of labour/work has replaced the succession in time by a succession in place. We are dealing with an already well developed system of social production and an economy based on a social distribution of labour in which there are available all the various stages of the production process. As such, the notion that "waiting" is required makes little sense. This can be seen from the fact that it is not the capitalist who grants an advance to the worker. In almost all cases the worker is paid by their boss after they have completed their work. That is, it is the worker who makes an advance of their labour power to the capitalist. This waiting is only possible because "no species of labourer depends on any previously prepared stock, for in fact no such stock exists; but every species of labourer does constantly, and at all times, depend for his supplies on the co-existing labour of some other labourers." [Thomas Hodgskin, Labour Defended Against the Claims of Capital] This means that the workers, as a class, creates the fund of goods out of which the capitalists pay them.
Ultimately, selling the use of money (paid for by interest) is not the same as selling a commodity. The seller of the commodity does not receive the commodity back as well as its price, unlike the typical lender of money. In effect, as with rent and profits, interest is payment for permission to use something and, therefore, not a productive act which should be rewarded. It is not the same as other forms of exchange. Proudhon pointed out the difference:
"Comparing a loan to a sale, you say: Your argument is as valid against the latter as against the former, for the hatter who sells hats does not deprive himself.
"No, for he receives for his hats — at least he is reputed to receive for them — their exact value immediately, neither more nor less. But the capitalist lender not only is not deprived, since he recovers his capital intact, but he receives more than his capital, more than he contributes to the exchange; he receives in addition to his capital an interest which represents no positive product on his part. Now, a service which costs no labour to him who renders it is a service which may become gratuitous." [Interest and Principal: The Circulation of Capital, Not Capital Itself, Gives Birth to Progress]
The reason why interest rates do not fall to zero is due to the class nature of capitalism, not "time preference." That it is ultimately rooted in social institutions can be seen from Böhm-Bawerk's acknowledgement that monopoly can result in exploitation by increasing the rate of interest above the rate specified by "time preference" (i.e. the market):
"Now, of course, the circumstances unfavourable to buyers may be corrected by active competition among sellers . . . But, every now and then, something will suspend the capitalists' competition, and then those unfortunates, whom fate has thrown on a local market ruled by monopoly, are delivered over to the discretion of the adversary. Hence direct usury, of which the poor borrower is only too often the victim; and hence the low wages forcibly exploited from the workers. . .
"It is not my business to put excesses like these, where there actually is exploitation, under the aegis of that favourable opinion I pronounced above as to the essence of interest. But, on the other hand, I must say with all emphasis, that what we might stigmatise as 'usury' does not consist in the obtaining of a gain out of a loan, or out of the buying of labour, but in the immoderate extent of that gain . . . Some gain or profit on capital there would be if there were no compulsion on the poor, and no monopolising of property; and some gain there must be. It is only the height of this gain where, in particular cases, it reaches an excess, that is open to criticism, and, of course, the very unequal conditions of wealth in our modern communities bring us unpleasantly near the danger of exploitation and of usurious rates of interest." [The Positive Theory of Capital, p. 361]
Little wonder, then, that Proudhon continually stressed the need for working people to organise themselves and credit (which, of course, they would have done naturally, if it were not for the state intervening to protect the interests, income and power of the ruling class, i.e. of itself and the economically dominant class). If, as Böhm-Bawerk admitted, interest rates could be high due to institutional factors then, surely, they do not reflect the "time preferences" of individuals. This means that they could be lower (effectively zero) if society organised itself in the appropriate manner. The need for savings could be replaced by, for example, co-operation and credit (as already exists, in part, in any developed economy). Organising these could ensure a positive cycle of investment, growth and savings (Keynes, it should be noted, praised Proudhon's follower Silvio Gesell in The General Theory. For a useful discussion see Dudley Dillard's essay "Keynes and Proudhon" [The Journal of Economic History, vol. 2, No. 1, pp. 63-76]).
Thus the key flaw in the theory is that of capitalist economics in general. By concentrating on the decisions of individuals, it ignores the social conditions in which these decisions are made. By taking the social inequalities and insecurities of capitalism as a given, the theory ignores the obvious fact that an individual's "time preference" will be highly shaped by their circumstances. Change those circumstances and their "time preference" will also change. In other words, working people have a different "time preference" to the rich because they are poorer. Similarly, by focusing on individuals, the "time preference" theory fails to take into account the institutions of a given society. If working class people have access to credit in other forms than those supplied by capitalists then their "time preference" will differ radically. As an example, we need only look at credit unions. In communities with credit unions the poor are less likely to agree to get into an agreement from a loan shark. It seems unlikely, to say the least, that the "time preference" of those involved have changed. They are subject to the same income inequalities and pressures as before, but by uniting with their fellows they give themselves better alternatives.
As such, "time preference" is clearly not an independent factor. This means that it cannot be used to justify capitalism or the charging of interest. It simply says, in effect, that in a society marked by inequality the rich will charge the poor as much interest as they can get away with. This is hardly a sound basis to argue that charging interest is a just or a universal fact. It reflects social inequality, the way a given society is organised and the institutions it creates. Put another way, there is no "natural" rate of interest which reflects the subjective "time preferences" of abstract individuals whose decisions are made without any social influence. Rather, the interest rate depends on the conditions and institutions within the economy as a whole. The rate of interest is positive under capitalism because it is a class society, marked by inequality and power, not because of the "time preference" of abstract individuals.
In summary, providing capital and charging interest are not productive acts. As Proudhon argued, "all rent received (nominally as damages, but really as payment for a loan) is an act of property — of robbery." [What is Property, p. 171]