The Agio

The first modern theory to give interest a clean foundation located it not in money, and not in machines, but in the mind — in a universal human tilt toward the present. Interest exists, this theory holds, because people would rather have things now than later, and must be paid a premium to wait.

The Austrian economist Eugen von Böhm-Bawerk gave the idea its first systematic form. Present goods, he argued, are simply worth more than future goods of the same kind and quantity, and interest is the agio — the premium, the markup — at which the one exchanges for the other. He offered three grounds for the premium. The first is a difference in circumstances: we generally expect to be better provided for in the future than in the present, and a good matters less to a man who expects to be richer, so future goods are discounted by the very expectation of future plenty. The second is a quirk of psychology: we systematically underrate future wants, feeling them less vividly than present ones — a failure of imagination that makes the future seem to matter less merely because it is not yet here. The third is technical: present goods can be set to work in roundabout, time-consuming methods of production that yield more than direct ones, so a good available now commands more future goods through its productive use.¹

Irving Fisher, a generation later, refined the theory into the form economics still teaches. The rate of interest, Fisher showed, is settled by the meeting of two forces: impatience and opportunity. Impatience is time preference — the subjective rate at which a person will trade present for future consumption, his own premium on the now. Opportunity is the objective rate at which the economy can transform present goods into future ones through investment — the productivity of waiting. In equilibrium the market rate brings the two into line: each person borrows or lends until his impatience matches the rate, and investment is pushed until its return matches it too, so that a single rate equates everyone's time preference, at the margin, with the productivity of capital.²

The theory's power is that it needs no money at all. Fisher's interest is a real phenomenon — a fact about goods exchanged across time, which would exist in a moneyless economy of barter between present and future. The rate measures the terms on which a society, as a whole, is willing and able to trade the present for the future: high where people are impatient or opportunities to invest are rich, low where people are patient or opportunities scarce. It is the price of time in the most literal sense the words allow — the premium on now — and it gives the deferral of a dollar a clean and intuitive meaning: a dollar next year is worth less than a dollar today because, between the two, lie both our impatience and the return we forgo by waiting.³

But to ground interest in impatience is to rest a vast and consequential magnitude on a foundation that is neither stable nor clearly rational. Why should a future satisfaction be worth less than an identical present one? Pure time preference — discounting a future good merely because it is future, setting aside any expectation of greater wealth and any risk that it may not arrive — has struck many careful minds as indefensible. Ramsey called the discounting of future satisfactions a practice that springs only from a weakness of the imagination; others have called it a polite name for selfishness, toward one's own later self and toward the generations to come. And Böhm-Bawerk's own second ground concedes as much, for it rests the premium partly on a cognitive error — the systematic underrating of wants not yet felt. A theory that grounds the price of time in impatience thus grounds it in a mixture of prudence, myopia, and mere preference for the present — and the impatience, a later plate will show, is not even consistent with itself across time.⁴

There is a second difficulty, and it is the one that opens onto the next plate. Fisher's theory has two blades — impatience and opportunity — and the opportunity blade is nothing other than the productivity of capital: the technical capacity to turn present goods into more future goods. The agio theory, in other words, already contains the productivity theory of interest as one of its two halves. And that half cannot be ground without trouble, for to speak of the productivity of "capital" one must first say how much capital there is — and the quantity of capital, it will turn out, cannot be measured without already knowing the rate of interest the theory was meant to explain. Pull on the opportunity blade, and the scissors will not close.⁵

Time preference makes interest a fact about us — our impatience meeting the world's productive opportunities — and it remains the most psychologically satisfying account of the rate, the one that gives the premium on the present an immediate human meaning. But it purchases that meaning at a price: it rests the rate on an impatience that is neither stable nor clearly rational, and it smuggles in, through its second blade, the productivity of capital, whose measurement dissolves into paradox. The next plate takes up that second blade directly, and finds that the objective, technical theory of interest — the one that would locate the rate in the machines rather than the mind — cannot, at its foundation, say what the rate is without first assuming it.