The Bear’s Lair: Time Preference in Reverse

Edward Chancellor’s admirable “The Price of Time” (Allen Lane, 2022) demonstrates clearly that interest rates are a matter of time preference; lenders charge interest because $1 today is worth more than $1 in say two years’ time. That is all very well, but at present, with markets heading downwards, interest rates heading upwards and interest rates still far below inflation rates, a real $1 in September 2024 is likely to be worth considerably more than $1 today. Time preference for rational investors has thus gone into reverse; it is worth discussing the strategies and economic implications of this bizarre phenomenon.

Inverted time preference is not something the world has seen very often. Theoretically, it could happen in periods of deflation — $1 in the United States of 1879 was worth around 15% less than in the U.S. of 1893. But in practice during that period, $1 in 1879 could have been invested in common stocks of U.S. industrial companies and it would have done pretty well – the 1880s were a period of industrial expansion, and those few industrial stocks that were publicly traded shared in that expansion. There were no share indexes that far back, but the late 1880s in particular saw a substantial bull market, despite deflation overall (and correspondingly high real interest rates). Naturally, prime bonds would also have been a good investment.

The 2010-2020 period purported to be one of reverse time preference, but it really wasn’t. Interest rates were substantially negative in real terms, it is true, with consumer prices rising about 18% over the decade and interest rates near zero. In Europe and Japan, with negative nominal interest rates or Britain, with more inflation, real rates were even more significantly negative. Yet the prices of stocks, real estate and many other assets soared. $1 in 2010 was worth hugely more than in 2020 because it could have been invested in almost anything and have made money in real terms, producing far more than $1 in 2020. There was a lot wrong with economic conditions during that decade and even more wrong with policy, but time preference was not reversed, at least with the benefit of hindsight.

A true period of inverted time preference was 1929-32. John Paul Getty once said that the way to become a billionaire was to start as a millionaire and buy in 1932. The problem, and the reason why everybody in that generation did not become a billionaire, was that hanging on to your modest million in 1929-32 was remarkably difficult. If you had it in the stock market, it lost 88% of its value, becoming a mere $120,000. The most sensible thing to do with it was to turn it into gold or banknotes and put it in an old sock (or, to be fair, a drawer full of old socks) and then hope that Al Capone, Bonnie and Clyde, Little Caesar or any other of the bad guys running round America at that time did not steal it. If you could just hang on to it, your $1 in 1932 would be worth far more than it had been in 1929, whether for buying apples, General Motors shares or Texas and California oil properties.

Another equally good example of reverse time preference, now lost in the mists of antiquity, is 1720, the year of the South Sea Bubble. Robert Walpole sat out the Bubble; by doing so he was able to become prime minister for 21 years, build Houghton Hall and end the careers of those who had promoted the South Sea Company. A pound in June 1720, at the peak of the mania, was worth very little to him; a pound in 1721, after the mania had burst, was worth much more – for one thing, he could buy pictures at discount prices and build the country’s finest collection, now the core of the Hermitage collection in St. Petersburg.

That same year, cash owned by the French depositors in the Banque Royale, at the height of John Law’s Mississippi Scheme, was worth precisely zero to them. The Banque Royale went bankrupt and, to prevent any embarrassing claims, its papers were burned so that there was no written record of those who might have a claim against the French state. That exceptionally thorough default immiserated the French middle classes and much of the aristocracy, created a poisonous salon culture of those who had lost their chateaux, destined France for defeat in all its wars against Britain, deprived the country of savings with which it might have begun to build industrialism and in the long run led to the French Revolution.

The economic effects of the periods of reverse time preference are clear. If money in say three years’ time is worth more than money today, then there is not the slightest point in engaging in risky investments, which reduce the chance of your still having the initial capital’s value in three years’ time. Once investors realize they are in a period of reverse time preference, and for many years afterwards, risk aversion goes to infinity and stays there.

We saw this in the period after 1933, when even several years of a strong stock market and recovering economic conditions failed to tempt investors – in the late 1930s the value of equity issues on Wall Street dropped to almost zero, and it was the middle 1950s, an entire generation later, when the market losses from 1929 had been entirely recovered, that risk aversion returned to a more normal level. Even then, it was extraordinarily difficult for substantial new businesses to get capital – the founders of Digital Equipment Corporation in 1957 had to give away 70% of their company to the private equity firm American Research and Development to obtain venture capital financing of only $70,000 (equivalent to perhaps $3 million today).

Similarly, risk aversion even in Britain went to infinity after 1720 (though a partial bailout of the South Sea mess prevented an economic and social meltdown as in France). Thomas Newcomen’s steam engine, an entirely new and extremely important technology, got the £21,600 of venture capital it needed (about five times the Digital Equipment financing, in real terms) in 1715 with the help of the Sword Blade bank, the principal entrepreneurial finance house of its time. (You could negotiate for Newcomen engines with Thomas Newcomen himself on Wednesday afternoons at the Sword Blade Coffee House.)

Regrettably, Sword Blade was also the principal organizer of the South Sea Company and therefore went bankrupt in that enterprise’s 1720 crash. After 1720, there was no Sword Blade, a Bubble Act preventing new incorporations, and a deeply economically retrograde Whig government for the next 42 years. Consequently, there was no successor to the inefficient Newcomen engine design until James Watt’s first engine sale in 1776, and the incipient Industrial Revolution was stopped in its tracks for half a century.

During a period of reverse time preference, as we are entering, risky investment, whether in stocks, real estate or anything else is irrational. (Yes, artworks also – the Tate Gallery was able to buy all three of its J.W. Martin masterpieces for £7 in 1935, because the art market had collapsed so badly in 1929-32). If, as in 1720 or 1929, we had a proper Gold Standard monetary system, we should clearly hold cash and rejoice as others’ investments collapsed around us. Regrettably, we are now in a fiat currency system, where as Argentina has proved countless times, even cash cannot be relied upon.

If there was a reliable store of value, which we might be using for money when the period of reverse time preference ends, I would recommend it, but there isn’t. The protections against inflation built into Bitcoin’s blockchain are only moderately solid, and the protections against fraud in the cryptocurrency world are far too weak.

Hence, very tentatively, I would recommend gold, but without any great conviction that the world will have the sense to return to that admirable metal as a monetary basis.

(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)