Revealed preferences for discount rates
06/12/2011 § 2 Comments
NZIER (and Motu and The Treasury) hosted a workshop on discount rates yesterday, led by Prof. Weitzman. We discussed, amongst other things, whether Treasury’s 8% discount rate is too high. It is, apparently, at the high end of international rates. Partly in response, there was a comment this morning from Michael Reddell:
NZ already does a high level of public investment (% of GDP) by OECD standards, and the real cost of borrowing (and probably of equity) is high by advanced country standards. Since the limits of (public and private) leverage have proved more binding in the last few years than had generally been anticipated, decisions to undertake materially more public investment (a consequence of using a lower discount rate) would have real and material consequences for the level of consumption undertaken in the near-term.
The points about the level of public investment and international costs of capital are important. They do suggest that there are constraints.
I would suggest, though, that New Zealanders are very happy to invest despite low returns (or high costs of borrowing). The problem is how we are defining the ‘right’ rate to consider. On the one hand, research suggests that the real return on equities is 8% in NZ. This sets the benchmark. On the other hand, lots of households are happy to invest in small businesses and rental properties. The rates of return are defined as ‘low’ because they are low compared to the 8% benchmark. Then, economists go around trying to find all sorts of explanations for the aberrant behaviour. There is quite a list: poor information, wrong expectations, tax policy, ‘fascination’ with property, preferences to go it alone, etc. And, yes, there is some truth to all these explanations.
We could just as easily turn it around. Kiwi households are willing to invest for a solid 2%-3% return on their houses and farms, with a long-run view to building family wealth. The 8% in the equities market is then the aberration, something that needs to be explained by reference to risk-taking, liquidity preferences, or whatever. Or, if we want to avoid making judgements about people’s preferences (don’t we?), how about a weighted average cost of capital across all investment classes?
And just to close: Michael notes that making more investment for the long term would have consequences for consumption in the near term. This is true. It is the essence of the trade-off we are making: exchanging less consumption today for more consumption tomorrow. The question, though, is the ‘right’ price for the exchange.