Professor Miles Kimball from the University of Michigan recently spent a few weeks at The Treasury. Kimball has written a lot about the need for central banks and governments to be more active to overcoming the technological and/or legislative constraints that have allowed the near-zero lower bound to become a major constraint on monetary policy in much of the advanced world. Weak demand has been a major constraint in much of the West in recent years, and the limits on monetary policy have been a material part of that story. (Monetary policy mistakes, by central banks in places like the euro-area, Sweden and New Zealand haven’t helped.)
We had a good conversation about the ZLB issues while Kimball was here. My sense is that the ZLB issues are again becoming more pressing globally. That makes it highly regrettable that our Reserve Bank has done no pre-emptive work, and appears uninterested in doing any such work, about avoiding the constraint becoming an issue in New Zealand. They’ve invested in interesting research on making sense of other countries’ interest rate yield curves in the presence of the zero lower bound, but not on the practical policy options for New Zealand to overcome the constraint.
A reader pointed me to another topic that Kimball spent some time on while he was in New Zealand. Last week, he devoted a substantial blog post to the question of the appropriate discount rate to use in evaluating New Zealand government projects. The Treasury recommends that, as a default, a pre-tax real discount rate of 8 per cent should be used in evaluating most government projects (including regulatory ones). Kimball, learning of this, notes that “this custom makes no sense to me”, arguing in effect that the New Zealand government should be much more willing to borrow to undertake projects, or to invest in international equity markets through the government’s highly-leveraged hedge fund, the New Zealand Superannuation Fund (NZSF).
As Kimball notes, the government’s borrowing costs are quite low (by historical standards, although not by international standards). Real long-term government bond interest rates are just over 2 per cent at present, and implied forward rates even fifteen years ahead are probably no higher than 2.5 per cent. No one knows what the future holds. Many people expect global real interest rates to rise at some point, but even if that happens there is no necessary reason to think that New Zealand real interest rates over the next 30 to 50 years will be materially higher than they are now. Long-term global population and productivity trends don’t look as though they would support equilibrium real interest rates much above (or even as high as) 2.5 per cent.
But using a bond yield to evaluate long-term government projects just seems wrong. Finance theory typically encourages people to evaluate projects using a weighted average cost of (debt and equity) capital. And, in practice, in evaluating projects corporations appear to use required rates of return that are higher than estimates of their cost of capital. The cost of capital isn’t directly observable, but (for example) estimates of the market equity risk premium (the cost of equity over risk-free debt) have often been in the 4 to 7 per cent range. Treasury appears to be using a 7 per cent equity risk premium.
I was struck reading Kimball’s material that the cost of the government’s equity did not get a mention. There was a strong tendency to treat the government as an autonomous agent (like a household) managing its own wealth, whose low borrowing costs depends only on the innate qualities of the government and its decision-makers. But that is simply wrong. A government’s financial strength – and ability to borrow at or near a conceptual “risk-free” interest rate – rests on the ability and willingness of the government to raise taxes (or cut spending) as required to meet the debt commitments. That ability to tax is implicit equity, and it has a cost (an opportunity cost) that is considerably higher, in most cases, than 2.5 per cent real. So long as the government will raise taxes as required, the bondholder bears none of the downside if a project goes wrong. But shareholders – citizens – do. Bearing that risk has a cost, and that cost needs to be taken into account by government decision-makers.
There is a related argument sometimes heard that governments should do infrastructure projects rather than private firms simply because the government’s borrowing costs are typically lower than those of a private firm. But, again, that rests on the power to tax, and the ability to force citizens/residents to pay additional taxes has a cost from their perspective (even if the government never chooses to exercise the option). As citizens, the possibility that the government will raise taxes (or cut other spending programmes – eg NZS) impinges on our own ability and willingness to take risks, and hence to consume or invest in other areas. That often won’t be a small cost. The opportunity cost of the government not undertaking a project is not what, say. the NZSF might be able to earn on the funds, but what citizens themselves might prefer to do if that risk-bearing capacity was freed up..
There is also a variety of rather philosophical arguments around whether it is morally correct to discount some far-future costs and benefits at any material discount rate at all. If, for example, a particular policy would have benefits now but (with certainty) would turn New Zealand into a wasteland 100 years hence, a conventional discount rate would give that far-distant cost almost no weight. But most projects (physical or regulatory) that governments are evaluating aren’t remotely of that sort, and conventional project evaluation techniques seem a sensible starting point. We have too little disciplined analysis of the costs and benefits of most government projects, and too little willingness to allow decisions to be guided by the results of the analysis when it is undertaken (did I hear the words “Transmission Gully”?).
I don’t have a strong view on whether 8 per cent is the “right” real discount rate to use in evaluating government projects, but the government bond yield is just not the appropriate benchmark.
The Reserve Bank of Australia recently ran an interesting and accessible Bulletin article on the required hurdle rates of return that businesses use in Australia. They report survey results suggesting that most firms in Australia use pre-tax nominal hurdle rates of return in a range of 10-16 per cent (the largest group fell in the range10-13 per cent, and the second largest in a 13-16 per cent band). Recall that nominal interest rates in Australia are typically a little lower than those in New Zealand, and their inflation target is a little higher than ours. In other words, it would surprising if New Zealand firms didn’t use hurdle rates at least as high in nominal terms as those used by their Australia peers. The RBA reports a standard finding that required rates of return were typically a little above the firms’ estimated weighted average cost of capital. The literature suggests a variety of reasons why firms might adopt that approach, including as a buffer against potential biases in the estimated benefits used in evaluating projects.
As a citizen, it is not clear why I would want to government to use scarce capital much more profligately than private businesses might do. I use the word “profligately” advisedly – using a lower required rate of return puts less value on citizens’ capital than they do themselves in running businesses that they themselves control. And if the disciplines of the market are imperfect for private businesses (as they are), the disciplines on public sector decision-makers to use resources wisely and effectively are far far weaker. Fletcher Challenge took some pretty bad investment decisions in the 1980s and 1990s: its shareholders and managers paid the price and the firm disappeared from the scene (along with many more reckless “investment companies”). The New Zealand government, architect of Think Big debacle, lives on – citizens were the poorer, but ministers and officials paid no price.
If anything, there are several reason why governments should be using higher discount rates than private citizens would do:
- Governments raise equity (“power to tax”) coercively rather voluntarily, and effectively impose near unlimited liability on citizens.
- Governments are subject to fewer competitive pressures and market disciplines to minimise the risk of resources being misapplied.
- Many government investment projects exaggerate the exposure of citizens to the economic cycles (the projects go bad when the economy goes bad)
I wouldn’t necessarily push that case strongly, and it is hard enough to get disciplined use of public money even with an 8 per cent real discount rate, but we should resist the siren calls to apply even lower discount rates.
Finally, Kimball seems to have become fascinated by the New Zealand Superannuation Fund. Ever since I started this blog, I’ve been meaning to write something on NZSF, but haven’t yet got that far down my list. Today isn’t the day, but suffice to say that even if the NZSF were to offer high expected returns (a) it is doubtful that those returns would get over a typical corporate hurdle required rate of return, and (b) since the returns to the NZSF are highly pro-cyclical, losses are likely to be largest at just the points when the taxpayers (and the rest of government) are under most financial stress, and calls for additional fiscal stimulus will typically be largest. There was perhaps a plausible case for NZSF 15 years ago, enabling the Minister of Finance to protect surpluses from his colleagues, and to delay the sort of spending binge that happened after 2005 anyway. But there is no reason to think that the New Zealand government will prove to be a superior leveraged investor in global markets, and no obvious reason to coerce citizens to participate in such leveraged punts.
11 thoughts on “What price should be put on proposed government projects?”
Nice one Michael. I believe that one should treat finance as freely available but very expensive.
I really can’t see any risky venture getting financed at an IRR of 15% except in a boom and bubble. Not sure what IRR you would need to finance a viable gold mine at the moment (ie in a post bubble environment) but I would expect it to be north of 30% in order to have any chance of being able to raise finance. The point is the IRR the market demands varies as the perceived risk of the project and industry changes.
Of greater concern to me is the Hand of Death of government, where a project the market sees as viable is destroyed by the regulatory hurdles put in its way. This is the destruction by omission, the inverse if you will, to “If, for example, a particular policy would have benefits now but (with certainty) would turn New Zealand into a wasteland 100 years hence, a conventional discount rate would give that far-distant cost almost no weight.”
The example I have in mind is Cadmium. As every farmer and soil scientist is aware we are poisoning are soils with Cadmium and the problem has no solution as it comes with phosphate rock from Morocco. There is a real question whether our soils will be regarded as too toxic to produce food in a 100 years time. Remember it is our customers who will decide this, not us. To me this is a much more real issue than “dirty dairy” which is simply remedied by market forces in the usual way, ie boom and bust.
So back to the Cadmium problem. What if an innovative geologist from Golden Bay (where even being a climate change sceptic would get you shunned) came up with a world leading solution; to mine phosphate nodules from under the sea on the Chatham Rise? “Eureka”, he thought, a local source of Cadmium free phosphate rock, wonderful. He then researched the undersea mining process and found it was viable, raised finance to investigate the environmental effects of the mining process and found they were minimal (the Chatham Rise being a no fishing area chosen by the fishing industry because there are no fish there). $10 million dollars later (try raising that amount without a solid case) a judge says “No, the environmental benefits are unproven”. All new and innovative things are unproven. The Hand of Death.
The reason New Zealand is a backward agrarian nation is because of the sum of regulatory processes and decisions such as this. I mean,we missed a once in a century mining boom, how pathetic is that?
Thanks Richard. Charles Murray’s recent book, The Regulatory State, is good on this sort of thing in a US context.
I see it everywhere I look. Kiwis worship monopolies – eg Fonterra. Monopolies do not need to reform continuously and incrementally and therefore carry on being managed for the benefit of management until so they are so out of date they are destroyed. Solid Energy comes to mind. If you want to encourage bad practise in an industry you just have to nationalise it and subsidise it, management will do the rest.
We have such things as the Tourism Board which organises advertising and bookings but it’s market dominant position makes it well nigh impossible for better alternatives to get going. They do a good job by and large but what brilliant innovation do they prevent? What is the cost of the lost opportunity?
Likewise there are calls for Meat Board and centrally organised marketing. What about something from this century like top quality organic grass fed Angus beef from a farm you can visit? We are 30 years behind our customers in Europe.
Better still, why not organic grass fed Aberdeen Angus, Hereford, Red Devon or Belted Galloway. The possibilities are endless.
Those are astronomical discounts and hurdles. The marginal ROI in the USA is probably around 6% nominal right now, though it could well be less. You can see how little revenue growth there is and the cash just piles up. Meanwhile, the little bit of work that seems to have been done on the ROI of public projects seems to indicate in the transportation sector something in the mid-teens for roads, rail, transit, ports, airports, etc. Perhaps other areas of public investment could offer higher ROIs (I’m guessing education spending would pencil out quite high). The idea that the opportunity cost of tax equity in the USA is high seems upside down. I would be very surprised if OZ and NZ are any different.
(To see what is happening in the US corporate sector one must ferret out marginal investment opportunities, which currently look much different from reported profits, as these are generally yields on legacy projects. New opportunities are few and low return.)
(much as I hate using Wikipedia for anything) I see reference here to a typical required rates of return in the US being around 12% (which appears to have been drawn from Ross).
But if the public sector transport infrastructure projects really did offer mid-teens returns (US or NZ) I’d probably be all in favour of doing them. The major roading project I alluded to in my post (Transmission Gully, a big motorway extension out of Wellington) certainly would reach those sorts of rates of return, even on the relevant govt agency’s own numbers.
12% ain’t possible right now. wiki authors likely confuse or simply ignore marginal vs average ROI. I would like to emphasize it is a *very* rare analyst to do the proper work on it.
You say that
“there is no reason to think that the New Zealand government will prove to be a superior leveraged investor in global markets, and no obvious reason to coerce citizens to participate in such leveraged punts.”
Here is a link to piece I wrote for the Bank of England that explains why national treasuries should invest in their own stock market. An important component of the argument is that a fund of this kind should be traded countercyclically.
Click to access qb130411.pdf
[…] istoric în care s-a ajuns la această cifră este mai puțin important. Mai relevante mi se par observațiilelui Michael Reddell, în special ideea că pragul de rentabilitate folosit pentru evaluarea […]
An 8% real discount rate made sense 20 years ago, but I struggle to see why Treasury would still demand that… it makes almost any project unviable in the current market…
The problem is that by demanding a high discount rate only the risky projects get approved, so instead of weeding out the dud projects as the policy is designed to do all you end up with is a bunch of risky projects. its a common problem in the corporate arena where directors are sold on bad projects because they demand too high a discount rate.
Generally corporates understand their cost of capital and add a margin for safety. A post tax cost of capital may be 8%, or 11.5% pre tax, plus, say 2.5% margin for safety = 14% pre-tax discount rate on projects. That makes some sort of sense, but one has to be careful with it, because there might be completely good projects that have a return of 12%, but are rejected because the hurdle is treated too much like a bright-line test.
I am interested in the idea of the Govt cost of equity. The reality is that the Govt, via legislation can appropriate almost any private asset or cash flow, thus the weighting of equity in the cost of capital calculation for the Govt has to be very high.
You could argue that the cost of equity of the private sector should be equal to the cost of equity of the Govt… so in that case a low borrowing rate (3%) would be completely useless if the cost of equity is closer to 20%… Assuming, say $1 trillion in private sector assets in NZ and $30 billion in Govt debt the true cost of capital for the Govt would be so close to 20% it wouldn’t matter…
But then either only risky projects would get built or no projects at all…
This needs work, but it is a very interesting area!