So far, most of the resource transfers we have discussed are assumed to take place, if not instantaneously, at least in a very short amount of time. But what about the transferring resources across time? How should society decide whether to consume one ton of coal today, or save that coal for next year? Should we adopt the advice of the Vice President of the United States, who advocates the abolition of the interest rate system for making decisions about resource allocations over time? Even if we took his advice about "quantifying the effects of our decision on the future generations," how would we implement it practically? How should we trade off the well-being of our generation with the well-being of the "seventh generation into the future?" After all, resources saved for future generations represent lost happiness for consumers today. Should the impact of a decision felt 150 years from now be given the same weight as an impact felt 1 year from now? Furthermore, who would be empowered to make these decisions ("Welcome back, Economic Dictator!")? These are tough questions. And yet, they must be addressed. Implicitly or explicitly, a society makes countlessly many decisions every day which profoundly impact both the current and future happiness of its consumers. Before we consider how an economy should allocate resources across generations, let's first examine how individuals allocate resources across time in a free-market economy.

ONE WAY WHICH INDIVIDUALS CAN ALLOCATE CURRENT RESOURCES FOR FUTURE CONSUMPTION IS THROUGH SAVING. Saving represents giving up consumption now in order to gain consumption in the future. When you take home your paycheck and stuff a certain percentage of it in a savings account or a Certificate of Deposit, you are saying--in effect--that you do not want to consume now, but would rather save your consumption for sometime in the future. You are storing happiness. You may be saving for retirement, for a new computer system, or for a child's education. But you are certainly saving for the sake of future consumption. Only a miser stores money for the sake of money. Everyone else saves money so that they can enjoy consumption later on (or so that their loved ones can enjoy consumption later on). So from now on, think of saving as storing happiness.

Now that we have an idea of what saving represents, let's turn to its counterpart, borrowing. BORROWING IS A WAY BY WHICH INDIVIDUALS CAN TRANSFER FUTURE CONSUMPTION TO THE PRESENT. Few families can afford to buy a home or a new car and pay for it all at once. Instead, they borrow the money from a lender. However, in order to induce a lender to give up his money, the borrower must promise to pay back an amount whose sum total is greater than the original amount of the loan. Why would borrowers ever agree to pay back more money than they borrowed? The answer lies in human nature.

Most people prefer enjoyment now over enjoyment later. Indeed, it's something for which they're willing to pay a premium. Instead of waiting three more paychecks to buy a big screen television set, a football fan might want it right now, in time for the Super Bowl. If the big screen television costs $1,000 to buy right now, but a total of $1,100 if bought on lay-away, the extra $100 can be thought of as the price the football fan paid for the immediate enjoyment of the television set.

By now, you're probably dying to know if there is some easy way to relate borrowing and saving, present consumption and future consumption. Of course, it's the interest rate. We know we promised to cut through the boring terms like "interest rate," but bear with us a moment, because interest rates may be more interesting than you think. Perhaps the best way to explain how interest rates serve to allocate resources over time is to consider each person's "own" interest rate, something we'll call their "personal interest rate."

To illustrate this, let's consider the situation of one of the authors of this book (let's call him "Max"). Max is a student paying for graduate school with only meager assistance from his parents and the federal guaranteed student loan program. Like most students, Max's life is a constant financial struggle. There never seems to be enough money for even the most basic necessities of life. Max rides a bicycle to school to save transportation costs. He washes his paper dishes to keep his household expenses down. He rarely goes out, even when the most desirable women on campus beg him for a date. ("Sorry, baby, I'd love to, but I'm a little short this month..No, I mean a little short on cash.") And a fancy dinner at home consists of a meal of beaner wieners (RECIPE: one (1) hot dog, carefully sliced, and slowly added to one (1) can of baked beans, gently brought to a boil over an open flame. For a special treat, try pouring the can into a sauce pan.)

As would surprise few, Max has a very high personal interest rate. Max is living off of very little money as it is, and he is already borrowing to help finance his education. Therefore, he values present consumption quite a lot. If pressed, Max would say his "personal interest rate" is currently around 20 percent. This means that Max would be indifferent between having $1200 dollars a year from now, or having a $1000 today. We can think of this in two ways. In order to get Max to save a $1000 today, we would have to guarantee that he receive something more than $1200 a year from now. Alternatively, Max would be willing to borrow $1000 today, as long as he could pay back less than $1200 next year.

Now let's consider the other author of this book ("Bob"). Bob is a family man with a wife, three children, and two dogs to support. As we discussed earlier, Bob is concerned about having enough money in the future to pay for his children's college educations, future dental bills, and the possibility of having to put in an expensive, French drain system around his house. With all this future consumption in mind, Bob values present consumption relatively little and wants to save his money. If pressed, Bob would admit to having a personal interest rate of around 5 percent. In other words, Bob would be willing to give up $1000 today as long as he received anything more than $1050 a year from now.

Now it seems that Max and Bob have an incentive to trade. Max would be willing to borrow $1000 as long as he could pay back less than $1200 next year. Bob is willing to lend $1000 as long as he can get more than $1050 a year from now. After a (perhaps lengthy) period of bargaining, we would expect that the interest rate established between the two will be somewhere between 5 and 20 percent. (BOB: "Hey, Max, I'm willing to lend you $1000 at 191/2 percent interest." MAX: "191/2 percent! That's outrageous! I thought you said your personal interest rate was only 5 percent?" BOB: "It is." MAX: "Forget it. Some friend you are." BOB: "Have it your way. Hope you enjoy those beaner wieners tonight!" MAX: "Where do I sign?")

Now imagine a million Max's, and a million Bob's (talk about a scary thought!). Each has his own personal interest rate, each wanting to either lend money, borrow money, or consume just equal to their current incomes. After the interaction of all these players, a market interest rate will be determined. What is the information contained in this market rate of interest?

We can think of each individual's personal interest rate just like a personal "willingness to pay" value. For example, a person with a personal interest rate of 10 percent is willing to pay approximately $1100 next year in order to have an extra $1000 right now. Since the market rate of interest is a price like any other price, we can use exactly the same logic that we used in Part I to determine the information contained in this price. In particular, THE MARKET RATE OF INTEREST TELLS US HOW MUCH HAPPINESS SOCIETY WOULD HAVE TO RECEIVE NEXT YEAR--MEASURED IN DOLLARS--TO COMPENSATE IT FOR GIVING UP A DOLLAR'S WORTH OF HAPPINESS TODAY. Alternatively, IT TELLS US HOW MUCH HAPPINESS SOCIETY IS WILLING TO GIVE UP NEXT YEAR--MEASURED IN DOLLARS--IN ORDER TO GAIN AN ADDITIONAL DOLLAR'S WORTH OF HAPPINESS TODAY.

If the market rate of interest is 10 percent, that means that the happiness of society would be increased as long it could get more than $1.10 worth of goods and services next year, in return for giving up $1.00 worth of goods and services today. If giving up $1.00 worth of consumption today results in an increase of less than $1.10 worth of consumption next year, society's happiness is lowered.

Now that we know the information that is contained in interest rates, we can see how free-market economies allocate resources over time. When a firm invests--say by building a new plant, researching a new line of products, or expanding capacity--it takes away resources that could have been used for current consumption, and directs those resources towards producing greater consumption in the future. THE MARKET RATE OF INTEREST GOVERNS HOW MUCH FIRMS WILL INVEST FOR THE FUTURE, AND HOW MUCH SOCIETY GETS TO CONSUME IN THE PRESENT. When a firm is deciding whether to invest in a project, the owner or manager will compare the projected rate of return from the investment against the cost of borrowing that money. If the firm expects to see a 15 percent return on its investment over the next year, and the market rate of interest is only 10 percent, the profit-seeking firm's choice is clear: it will choose to borrow the needed funds and proceed with its investment plans. However, if the firm decides that it will likely make only a 5 percent return on its investment, the firm will choose to scuttle the proposed project. It cannot make a profit if it borrows the money at a 10 percent interest rate. On the other hand, if the firm already has the money for the project, it could make a greater profit by lending it at the market rate of 10 percent.

The 10 percent market rate of interest is society's way of telling firms, "Hey, guys, listen up! If you want to produce more consumption goods for us next year, that's great. But you better be pretty sure you can produce at least 10 percent more goods with those resources you're taking away from us." If a firm believes it can generate a 15 percent return on its investment, then society's happiness will be increased. Oh sure, the investment will mean taking resources away from the production of current goods and services. But the extra goods and services that consumers will gain next year will more than compensate them for their current losses.

Alternatively, if a firm decides that its investment project will only generate a 5 percent rate of return, then proceeding with the project would serve to decrease society's happiness. In effect, society says to the firm--via the market rate of interest--, "Hey thanks for thinking of us. But we don't want you taking our resources away. We'd rather have the happiness that those resources could produce for us right now, rather than the happiness you'd be able to generate for us next year."