No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Twelve: Money Mischief 287 intermediation therefore smoothes consumption across time, so economists refer to this as inter-temporal (across time) coordination . As Wimpy the moocher says (the famous character in Popeye cartoons), “I’ll gladly pay you Tuesday for a hamburger today.” Now we all know that people in general prefer to consume today over a promise to consume tomorrow, so we need an incentive to postpone consumption. If you don’t believe this, answer this simple question: would you prefer $10,000 today or $10,000 twenty years from now? I don’t know of anyone who honestly doesn’t have a positive time preference (preferring current consumption over future consumption). Of course there are many reasons why people have a positive time preference: the uncertainty of the future, the productivity of capital, low morals, etc. But the reality of it seems to be a universal aspect of the human condition. Given this natural human condition of a positive time preference, people have to have an incentive wait—that incentive is the positive interest rate. You can think of the interest rate as the price of current consumption. Now there are multitudes of different interest rates, varying with time duration and riskiness of the borrower among other things, but for our purposes we will assume there is only one interest rate, which will simplify but not change the results of our analysis. When a bank loans you money, they will require the original amount back (the principal ), plus a payment for waiting ( interest ). As an example, let’s say you borrow $100 from the bank at an annual rate of 5% interest, due in one year. At the end of one year, you will owe the bank $105, which is the total of the principal ($100) plus the interest payment (5% of $100, or $5). If you borrow the money over two years, you will pay interest on the interest (known as compounding ). So at the end of the 2nd year you owe not just $105, but $105 plus $5.25 (5% of $105, the interest for the 2nd year) for a total of $110.25. We will discuss this a bit more formally in chapter 16 on finance, but for now you just need to understand that by abstaining from current consumption today, you can consume more in the future. The longer you wait to consume, the more you are able to consume since interest compounds over time. You may be willing to loan at 7% (by the banks intermediating your savings into a loan), but the combination of all market participants’ savings and investment decisions will determine the overall interest rate, just like the overall market demand and supply curves require a summation of individual demand and supply curves. We can see a notional interest rate equilibrium in Figure 12.7 . As the interest rate declines, more and more borrowers will have an incentive to borrow, which is why our demand curve slopes downward as expected. Specifically—and very importantly—longer-term borrowers will Time preference: the observation that people prefer consumption today over consumption of a similar item at a point in the future. Financial intermediation is an important part of an economy; economies that don’t have effective banking systems perform significantly worse than those that do. Note that this process of matching savers and borrowers is not part of fractional reserve banking, so our previous criticisms of that facet of banking doesn’t apply here. Principal: On a loan, this refers to the amount borrowed. Interest: Conceptually, interest is an expression of time preference. Numerically, it refers to how much someone will have to be compensated to defer consumption today, expressed as a percentage of the amount borrowed/ loaned. Compounding: The process of earning interest upon prior interest earnings. As interest is added to the principal over time, and this total is reinvested, the total rises at a faster rate as you “earn interest on the interest.” Inter-temporal coordination: refers to the coordination of consumption across time; this coordination is enabled by the interest rate.