Time – obviously – plays a fundamental role in economic life as well. Over several blog posts, we shall be exploring the nature and characteristics of Time’s role in LTF markets. This is the first in that series.
Similar to its role in physics and philosophy,Time’s role in wealth creation and sustenance continues to be an enigmatic, paradoxical mystery. The economists Lowenstein and Thaler identify “Intertemporal Choice” as one of the fundamental Anomalies in economic theory. The academic fields of behavioural economics and the neuro-psychology of inter-temporal decision making are still in their infancy; and the macro-economics of time and wealth is like most of macroeconomic theory – devastated by the North Atlantic Financial Crisis, but nevertheless limping along with a mixture of old-school theory holdouts living in denial of reality and the newbies unsure of the appropriate direction to commit for their intellectual pursuit. In this blog we will demonstrate theoretical neutrality and will eclectically pick up insights that seem potentially valuable in this central domain, irrespective of their provenance. We operate under the assumption that an integrated theory is quite irrelevant at this point; and its ability to help individuals advance their careers is actually beside the point – these being the traps that have ensnared modern macroeconomic theory. However, given the intellectually pragmatic necessity of a good theory – for ‘rationally bounded’ human beings – we shall stick relatively close to the economic tradition schools; on this issue as well. And we shall consequently follow Lowenstein and Thaler [above] in helping structure the issue for discussion. And since we can’t do any better than these two distinguished authors, we shall quote them extensively:
“lntertemporal choices, decisions in which the timing of costs and benefits are spread out over time, are both common and important. How much schooling to obtain, whom to marry, whether to have children, how much to save for retirement, how to invest, whether to buy a house, and if so which house to buy-all these vital decisions have strong intertemporal components.”
“…economic theory makes a precise and testable prediction, namely that (at the margin) people should discount money streams at the (after-tax) market rate of interest ( r ).
The existence of capital markets creates what amounts to an internal arbitrage opportunity for the consumer. If presented with an investment option that pays off at a rate higher than r, the consumer can enjoy greater consumption in every period by accepting the option and borrowing appropriately at rate r. Options that pay less than r should be rejected since they are dominated by lending in the capital market. The implication is that consumers should make intertemporal trade-offs so that their marginal rate of time preference equals the interest rate. Furthermore, consumers should be consistent in their intertemporal choices. The discount rate used should be constant across situations and over time. However, research shows that depending on the context examined, the implied discount rates of observed behavior can vary from negative to several hundred percent per year [emphasis added].
Some examples of economic anomalies – where the implied discount rate ≠ after tax market interest rate are:
- Individuals pre-paying taxes excess taxes instead of adjusting their withholding rates
- School teachers opting to have their 9-month salary paid over 12-months
- Life cycle consumption tends to increase over time; indicating binding borrowing constraints
- Myopia when it comes to energy-cost saving investments in home insulation and in energy saving air-conditioners, water heaters, refrigerators, freezers, etc.
Lowenstein and Thaler summarise the research literature by observing that:
“Discount rates observed in both laboratory and field decision-making environments are shown to depend on the magnitude and sign of what is being discounted, on the time delay, on whether the choice is cast in terms of speed-up or delay, on the way in which a choice is framed, and on whether future benefits or costs induce savoring or dread.”