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.