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.

 

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§ 2 Responses to Revealed preferences for discount rates

  • Michael Reddell says:

    Thanks for the comments Bill.

    You suggest that households are willing to invest for 2-3% (real?) returns. I rather doubt that those are the sorts of returns they expected. After all, (collateralised) floating mortgage rates over the last decade have averaged around 8 per cent, while unsecured SME overdraft rates have averaged more like 10 per cent. Even adjusting for inflation and tax one struggles to get down to a 2-3 per cent real borrowing cost, before allowing for any sort of premium for risk (variance).

    I wouldn’t strongly defend an 8% real return in the equity market, and I suspect that in any case the average public investment project hasn’t had to actually get past such a high hurdle, but a large equity risk premium is a pretty well-established feature of the data, here and abroad. If one allows anything for “government failure” in investment implementation (such that realised returns might fall short of those hoped for), one might well appropriately require a slightly higher ex ante rate of return on a public sector project than economic agents might look if they used the income or borrowing capacity to pursue their own business projects.

    Of course, it is worth noting that private investment in NZ is quite low (residential investment as a share of GDP is nothing startling given our rate of population growth) and the OECD ran a chart in their survey a couple of years back showing how real business investment per worker in NZ is very low by OECD standards (this chart was reproduced in the first 2025 Taskforce report)/

    • Bill says:

      Sorry for the delay in responding. I was looking for some quick stats and couldn’t find them, so I don’t come with any more data.
      My perspective is microeconomic: I have looked at the accounts of many SMEs and noticed that they don’t make much money. I don’t know how those observations roll up to the aggregate level. And yet, individuals and families continue to buy and run small businesses. The same is true of many farms: they aren’t particularly profitable. People often don’t get high rates of return on their investments, so might the money be better invested in public projects?
      You do allude to a serious issue: how do we use ex ante and ex post rates of return? Which one is more appropriate? Do we measure both and combine them to produce the official rate?

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