It is also unclear to me what exactly is meant by the time preferences “reasserting” themselves. What actions by what market participants does that term refer to?
Time preferences are asserted in the first place by the process of individuals, first, looking at their existing investments (if any) and their incomes, and second, then deciding whether to add to, maintain, or draw down their investments and altering their spending habits to suit. To add means to direct the resources received as income towards investment, while to draw down means to take resources out of investment and add to final consumption instead.
The root criterion is people’s varying preferences to consume now versus consuming in the future. Everyone, to varying degrees, prefers to consume sooner rather than later, but we can be induced to consume later (ie induced to invest instead), by the promise of getting a return on the resources we could use for either purpose. The core component of interest rates is the numerical manifestation of that time preference, which exists even before consideration of risk. Thus different people have different core risk-free rates of return that must be on offer in order for them to invest.
On top of that comes a risk premium for the amount of risk associated with an investment being contemplated. Most people are risk averse, that the more risk there is in a given investment the higher the return that people will want from it as compensation for bearing that risk. Just as there are different degrees of time preference for different individuals so are there different degrees of risk aversiveness for different individuals.
Lastly, in addition to the two core elements there is a third important element. There must also be a premium to compensate for a decline in (or, more rarely, a discount for an increase in) - the purchasing power of money. In short, there must be an inflation premium. The more that people expect the purchasing power of money to decline by the future time they will spend that money at, the higher the premium they will require as compensation.
Those three combined - the risk-free rate, the risk premium, and the inflation premium - are the great bulk of what makes up interest rates on loans and expected ROE’s on stocks. The market rates of return, whether in the form of debt interest or equity profits, are the aggregate of all individuals acting to supply or demand capital based on their time preferences, degrees of risk aversiveness, and expectations of changes in purchasing power. The actual ROR goes down as capital supplied goes up (ceteris paribus, of course), because that capital is funding more competition both for custmers and suppliers. The required ROR goes up as capital goes up because there is less need felt to invest and because as consumption goes down the per-unit value attached to what consumption is retained goes up. If the actual RORs are above the required RORs, people will invest more until the actual RORs come down and the required RORs go up to match. Likewise, if actual RORs are below the required RORs, people will withhold or withdraw investments until the actual returns rise and required returns fall to match.
A financial institution is a medium by which this aggregation process can take place more efficiently than would occur without it. However - and here is an important point - the actions of a financial institution cannot alter the two fundamental determinants, though it can alter the third through its influence on the money supply. Those two core determinents are the entirely province of the judgements of individuals, who are the true owners of all resources. All that an institution can do, through its taking resources from those individuals and investing them, is either speed up or slow down the adjustment of what actual returns are generated to line up with what kind of returns people would prefer to have for the varying risk levels. “Assertion” and “reassertion” is just reference to the aggregate of individuals’ preferences being eventually reflected in how investments are made. Ultimately, individuals producers and consumers will not be denied, irrespective of what intermediating institutions do in the short term.
A reassertion will start forming in the works when an institution (including government) starts acting to increase investment in a manner that is not warranted by aggregate time preference and risk aversiveness. An institution can only do this either by, first, lowering its reserve fractions, or, second, the central bank inflating the fiat currency and giving the new money to the financial institutions.
The mechanics of the reassertion start churning even before the funds exit the bank. The institution is in competition with others, so to fend off that competition it lowers its interest rates for given risk levels, yet increases its profits through an increased volume made possible by raiding the reserves or free booty from the central bank. Other institutions follow suit to meet that competition (many do, some don’t), and so returns are eventually lowered across all risk levels. The reassertion becomes due because the risk-return profile actually receivable in the marketplace is at now odds with what the individuals who own the resources would prefer, but the process must play itself out for the reassertion to be made manifest.
This is the process. The insitution then gets a business customer who borrows extra funds from it. The business then spends the funds to buy extra labour and capital goods. The revenue from the purchase of capital goods then becomes yet more income to other labourers, plus additional profit for the suppliers, interest revenue for debt investors, and more spending on yet more capital goods by them in turn. That process goes on and on, over time, until all spending can be resolved into personal income as wages, profits, or interest. As those funds make their way into the hands of individuals as personal income, those individuals must then decide what they are going to do with their money. That decision, in aggregate, is the beginnings of the reassertion itself. They decide as described above, by chosing whether to invest or borrow depending on the prevailing actual RORs and their required ROR’s. But, the actions of the originating institutions caused actual returns to fall, so that inclines people to save and invest less on the one hand and to disinvest (including borrow) to spend on consumption on the other. This action means that financial institutions start experiencing a drain on their funding sources, because people aren’t saving and investing at the same level as before. However, they don’t notice it straight away because they are initially getting additional funding either by raiding the reserves or getting a cut of central bank largesse and because as noted it takes time for the funding to fully make its way to the hands of individuals (there are also other capital goods and labour markets difficulties, but that’s secondary to the question at hand). That means at the start of a boom they can afford to lower their interest rates and creditworthiness criteria, but without an increase in the raiding or booty-gathering the assertion of individuals’ time preferences and risk premiums will force them to undo it to cover the cost required in regaining that funding.
To make matters worse, the extra consumer spending causes consumer prices to rise. When this happens the inflation that was generated by the government or the fractional bank starts to show up. This then occasions people to start expecting more price rises in future, which then inclines them to increase their inflation premiums required to invest. In turn, that makes them increase their overall required ROR’s quite substantially, in turn worsening the drain on financial institutions’ deposits etc.
So, now we have a problem: the action of instititions has artificially lowered actual ROR’s while increasing required ROR’s, with the consequences of the inflation making this situation harder and harder for the institutions to maintain. The only way that this can be maintained is by an acceleration of the reserves raiding or fiat currency expansion - but that only eventually acts to increase general prices and expectations of future inflation, increasing actual-required gap even more. The whole thing collapses when the institutions relent and allow the market rates rise to match required rates, ending the raiding party and so curtailing lending to business. The reassertion of time preferences in this context is that part relating to financial institutions curtailing their lending activities down to the level warranted by the funding that individuals will provide.
And why do the businessmen who plan the investments believe that a low interest rate today means they are going to be able to borrow at the same low interest rate 5 years from now? An interest rate is a price, and I have never heard of any rational manager expecting any prices to remain unchanged for years in a free market. Whenever you make a business plan, you have to factor in the possibility of the price of your own product declining, and the prices asked for by your suppliers
There is a local zinc smelter project that opened earlier this year and was forced to close down just a few weeks ago because they projected zinc prices to remain high (they fell) and coal prices to remain low (they rose). They whined in the local paper that they would never have opened up the smelter had they known that prices would change. Why is it so hard to expand that kind of mentality to others doing likewise in consideration of interest rates? Not every manager is always completely rational.
In a totally free market, there can be some cyclicality in the supply of goods that take a long time to produce caused by their producers being unable to predict the number of their competitors.
Yes, but without intereference in the financial markets through manipulation of interest rates and the money supply all the different markets’ variations as you speak of would largely diversify against each other, leaving behind a rather minor “noise” signal on top of what would otherwise be an orderly non-boom period of smooth growth that would follow the changes in time preference and risk aversiveness, both of which would change slowly in a laissez-faire economy. The issue is why there is such an enormous correlation of everyone investing and disinvesting at the same time, why everyone’s expectations of risk and changes in purchasing power all move in unison across the whole economy. In a laissez-faire economy the only vehicle for that is the financial sector through changes in reserve ratios down or up, while in a fiat-currency economy it is currency expansion and contraction, either scenarios of which move interest rates down or up accordingly and messing with people’s plans.
But a much more important factor in causing economic cycles in our present-day mixed economy is government intervention.
Intervention interferes with investment because it lowers actual returns through jacking up costs and raising expected returns through making people increase their risk premiums to compensate or expectation of more such costs in future (which may go all the way to mean total loss of capital). One of the reasons why the markets are jittery right now is because the government officials haven’t sorted out exactly what they are going to do, which makes for risk and uncertainty that are too difficult to pin down all that well, making it much harder to evaluate existing and potential investments in the current economic climate.
This definitely makes a contribution to the economic cycle, but it is not the originator of the core cycle at work.
One statist interventions you can count on to stymie any boom is … the raising of interest rates.
The offending banks must eventually raise rates because it cannot keep on doing what it has to do to keep them that low. If the offender is the central bank, it cannot keep on accelerating fiat currency expansion because that is leading to general price increases. It is partially doing the right thing, but only as a hyper-crude approximation of what would happen in a free market. If the offender is a normal bank, it cannot keep rates low because this it must eventually run out of reserves to raid, or have its profits cut because it raises offered rates to get more reserves in, or face a run (starting with a mere walk, so to speak) because it is losing customers.
JJM
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