By Anthony de Jasay
It is common in economic literature to use the term “time preference” to mean a preference for the present over the future. However, this need not be the case. It is counterfactual, but literally true, that if the future is preferred over the present, the marginal holders of present scarce resources would have to transfer them from the present to the future and starve as a matter of preference. By the same token, it is a counterfactual truth that if the present is preferred to the future, marginal holders of resources would transfer future resources to the present and look forward to starving tomorrow. Evidently, there are some additional assumptions, like production or holding of stocks, which would make the assumption of time preference realistic and not counterfactual.
Moreover, both consumption and production can be liable to fluctuations which would influence the preference between present and future. Other things being equal, oil refineries are liable to increase their stocks in the spring in order to satisfy rising demand for gasoline during the summer driving season. Flour mills may well draw down their reserves of grain in the winter in the expectation of plenty full supply from the forthcoming harvest. Commodity markets used to call the increasing demand and the rise in price from one period to the other the contango, and the increase in supply as the backwardation.1 Backwardation in the general, non-technical sense is the subject of the present column.
A holder of a resource at a point we shall call spot wishes to increase his holding at a future date when its price is expected to be higher in the market. He will either wait for the price to rise and leave his position uncovered, or increase his holding at present at the lower price, and thus have his position covered. The interest expense of the purchase at the lower price, and thus the cover of the position, will be the contango and the marginal holder would expect to be indifferent between an uncovered position and the covered position by the expense of the contango interest. For simplicity’s sake, we will leave out consideration of interest and storage expense as well as the subjective value, if any, between a covered and uncovered position.
If a holder expects the resource to be lower in price between the spot and a future date, he will either wait for the price to fall and leave its position uncovered, or decrease his spot holding and collect the interest between the spot and the lower future price at which he can cover his position. Abstracting the interest received and the subjective value, if any, of the difference between the covered and the uncovered position, he should be indifferent between the two alternatives. We are examining different market responses under backwardation but not under contango constellations. The contango corresponds to an inflationary and the backwardation to a deflationary horizon.
Negative Interest and Fear of Deflation
Negative interest serves to adjust the holder of a commodity in backwardation, i.e. in a position where he expects the spot price to be below the future price. In an economy overall, where commodity prices are just one of a multitude of influences, for spot price we have to think of the current price level, for the expected price level the future price, and for the interest rate the price of government securities, whether positive or negative. For the last ten years, negative interest rates have become an object of major interest and blame, because for some commentators, they were the cause of unprecedented low rates of interest, which in turn have played havoc with the accumulated savings of little people, pensions, life insurance, and many kinds of long term contracts. It also made it easy for governments to meet their deficits. Short-term government bills and bonds of most rich countries have turned negative and have continued to be negative for periods as long as ten years, as in the case of Japan. The queen of government securities, the ten year German “bund,” has only just escaped a negative interest rate, yielding a positive 0.32 per cent at the time of writing. It is characteristic of how Europeans and Americans think of their own perspectives compared to those of the opposite continent that the United States ten year Treasury bond is at 2.30 per cent, a fully 1 per cent interest differential between America and Europe.
While short-dated government and corporate securities may have a negative interest yield, the overall interest rate picture is positive but very low and signals deflationary expectations in the future. Neither policy nor the business cycle (if there is still such a thing) can possibly bring about such low interest rates if there were no fear of deflation. It is perhaps amusing to note that it is low interest rates that are blamed for low business investment, rather than the other way around.
Government policies are of course intended to counter the expectations of insufficient investment that have reduced economic growth since the beginning of the twenty-first century in Europe, and to a lesser extent in America. Government measures in history have often had perverse results and may have them again in the future.
One such measure is the quantitative easing by central banks that take securities, usually short-dated bonds, off the market and on to their balance sheets. The European Central Bank for instance, has bought 80 billion euro a month for the last year or so, and intends to continue such purchases in the New Year for at least a few more months. The holders of these securities had the manifest intention of carrying them, and agreed instead to sell them to the Central Bank in response to a small interest incentive. The Central Bank bought this paper at a negative interest rate, hoping that the former holders of these securities would replace them by buying business obligations, thus making the market more liquid.
“The solvency requirements imposed on the banks were in a sense like the Maginot line that an army was commanded to defend and that proved to be an ineffective defence compared to a mobile strategy.”
The other important policy measures brought about were the rather severe Dodd Frank Act regulations in the U.S. and the Basel banking and insurance regulations in Europe. Both sets of regulations are highly complicated, but their net effect, at least in Europe, although not so much in the United States, was to impose solvency ratios that made banks more reluctant to lend, so as to build up their own capital to a level that they might not have chosen in the absence of the Basel regulations. In other words, European Central Banks have sent some of their most highly trained officials to Basel to impose regulations on the banks that would make the latter more liquid and more solvent, while at the same time these highly trained officers conducted open market operations of 80 billion euro per month to make business more liquid and loans easier to get. The International Monetary Fund regarded both of these measures with approval. The solvency requirements imposed on the banks were in a sense like the Maginot line that an army was commanded to defend and that proved to be an ineffective defence compared to a mobile strategy. The open market purchases of the Central Bank of Europe, of the Federal Reserve in the United States and Japan must have had some of the desired effect in lowering interest rates, but they were hardly sufficient to dispel the fear of a deflationary turn in the foreseeable future.
The Central Banks of the world’s rich countries appeared to have much the same objective, that is that the general price level next year should rise by just under 1 per cent, which everybody considers as a benign non-inflationary rate of inflation (if the term is not non-sensical). This is perhaps as good as monetary policy can ever get, but not good enough to dispel an underlying fear of deflation. To restore a firm sense of confidence, one may need for the economy to show what it can do if at least a few of its handicaps are removed- handicaps that have accumulated in the course of trying to make it democratically more pleasing. The next few years may show whether there is any tendency in one direction or indeed of its opposite.
*Anthony de Jasay is an Anglo-Hungarian economist living in France. He is the author, a.o., of The State as well as other books, including Social Contract, Free Ride, Political Philosophy, Clearly, Political Economy, Concisely, Economic Sense and Nonsense, Helmut Kliemt, ed., and Justice and Its Surroundings. His books may be purchased through the Liberty Fund Book Catalog.
The State is also available online on this website.
For more articles by Anthony de Jasay, see the Archive.