Mar 18, 2019

Discounting the Future

A Macro Musings Transcript
David Beckworth Senior Research Fellow , James Broughel Senior Research Fellow

David Beckworth: Our guest today is James Broughel. James is a senior research fellow at the Mercatus Center and an adjunct professor of law at George Mason University Law School. He specializes in state and federal regulatory procedures, cost benefit analysis, and economic growth. James joins us today to talk about a recent symposium he hosted on the social discount rate; what it is, its uses and the controversy surrounding how to measure it. James, welcome to the show. 

While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to macromusings@mercatus.gmu.edu.

James Broughel: It's great to be here. Thanks, David. 

David Beckworth: Glad to have you on. And I know for some listeners, maybe social discount rate doesn't sound particularly sexy. But hang on, it is listeners. It's a very interesting and very important topic for policy issues and James will tell us why it is. But James before we get into it, tell us a little bit about yourself. How did you get into economics and then ended up down this road where you're thinking about cost benefit analysis and social discount rates? 

James Broughel: Sure. It's kind of a long story, I suppose. Not quite sure where to begin. When I was in high school, I was not very academic, I guess you might say, my grades weren't so great. I was really interested in music. I started playing guitar when I was 13. When all my high school classmates went off to college, I stuck around at home, worked a few jobs. And then when I was 19, I moved to New York City to pursue a career in music. I played in a number of bands over the years, kind of indie rock bands in Brooklyn. I was in one band where we signed with a small UK label, it's called One Little Indian Records. And we were able to put out a couple of records in the UK and tour around there a little bit and play some radio shows. 

David Beckworth: I never knew this about you, that's amazing. 

James Broughel: Yeah, so I had this whole music life. I'm kind of the kind of person who finds one thing and then I become obsessed with it, and like I just focus on that relentlessly. And in my teenage years and early 20s, it was music. But as the band that I was in, that I was really passionate about, kind of began to unravel and I sort of had a small taste of what life in a musical career might be like and it wasn't all that appealing, to be honest, for a lot of reasons, I started to look for other things. I had a girlfriend around that time in my mid 20s who bought me a subscription to The Economist magazine. I think she sensed that I had this kind of intellectual yearning. I don't know what it was, why she did that in particular, but I just started reading it cover to cover every week. And I really got into this economic way of thinking. 

James Broughel: I remember buying a book by Milton Friedman, Capitalism and Freedom around that time. I knew he was an economist, that was all I knew about him. I was just kind of blown away by that book. He talked about things like getting rid of doctors’ licenses. And this idea was so crazy and radical to me at the time. And yet, he argued it so forcefully and clearly. And so, I really got interested in economics and I started taking classes around that time at Hunter College, which is part of the City University of New York system. I knew I wanted to take economics classes, even though I wasn't even sure I wanted a college degree at that point. But I ended up just becoming kind of obsessed with economics, went through college, got a master's degree at Hunter and eventually got a job at the Mercatus Center focused on regulatory issues. 

James Broughel: I could talk about how that- 

David Beckworth: That's interesting. I'm still kind of stunned here. You're my colleague here and I never knew you were in a band. Interesting. 

James Broughel: I was the bass player by the way. But I also played guitar once in a while. 

David Beckworth: Can we get your albums somewhere still? Are they online? 

James Broughel: Levy was the name of the hand. If you search Rotten Love or Glorious, those are our albums. I think you can get them on iTunes. 

David Beckworth: Tell you what, we'll put a link up to our listeners if we can get a hold of it, amazing. 

David Beckworth: And also very interesting as with other guests I've had on the show, they tell their story. There's these pivotal people or events in life. So, this girlfriend, you can thank her, I don't know if you know her still. 

James Broughel: It didn't end well unfortunately but I'll always be grateful for that subscription. 

David Beckworth: Absolutely. And The Economist magazine. I mean, the influence that things have in our lives, very interesting. Well, I want to jump into this issue of social discount rates and the importance of them. And to make this a little more intuitive for some of the listeners who may not know now, now some of our listeners do know, so I beg your indulgence for those who do understand. I want to kind of work up to a slowly for the listeners who may not appreciate why this is important, okay. I want to start with thinking about a personal discount rate before we get to kind of a social discount rate. 

David Beckworth: So each of us has a personal discount rate and we all are implicitly, every one of us, we're subject to it. How do we value the future versus the present. We're making the decisions all the time. So I want to give two extremes, two types of people on how they value the present versus the future. You can weigh in on this, correct me where I'm wrong here. So I want to think of someone who's very much living for the moment. Let's say they're at the party, they're drinking too much, get crazy, they rob a bank, they steal a car, they go on a car chase, and they're destroying public property, they're living really for the moment. Let's call this person Charlie Sheen, all right, no particular reason. Charlie Sheen person here. 

David Beckworth: If I understand this idea correctly, they're effectively saying they're living more for the… they're putting more value on the present over the future. So they're discounting the future. 

James Broughel: Right. There are a few different reasons why someone might value their consumption in the future less than they value it today. And one it might be just be because they're kind of impatient or they just don't value themselves as much in the future or their own utility. And so, that's usually described as meaning you have a high pure rate of time preference. So that might describe Charlie Sheen. That doesn't necessarily mean that you're irrational or you're making bad decisions necessarily if you plan ahead. 

James Broughel: So for example, if you borrow a lot to consume a lot today because you value present consumption, as long as you kind of plan so that you're able to pay that back in the future, then there's nothing wrong with that. But it's when people kind of aren't really taking into account the future that maybe you might say there's something wrong or irrational with their decision making. 

David Beckworth: But your point would be someone then who maybe they find out they're going to die in six months and they rationally plan to, obviously, the future is going to be worth less. Their discount rate may change in that point. is that an irrational way? 

James Broughel: Well, essentially, it's people's consumption behavior that really changes over the course of their lifetime to bring their underlying preferences, like their rate of time preference or their rate of diminishing marginal utility, how much less utility they get as they get wealthier. It's their consumption patterns that should change in order to bring those underlying preferences into alignment with their market conditions with the interest rates that they face. So a rational person should…their discount rate really should equal the relevant interest rate that they face. And it's their consumption really the changes as opposed to their discount rate. 

David Beckworth: For a rational person. But you could have someone, I guess, why would someone have a very, very high discount rate, my Charlie Sheen example, why would that be, just underlying preferences? 

James Broughel: Just underlying preferences. 

David Beckworth: His values, he's born that way, he's just, it's not a question of being short-sighted, it's just a question of preference. What are the preferences? 

James Broughel: Usually economists don't try to judge people's underlying preferences. I mean, there might be a string of behavioral biases like myopia or something along those lines that might explain why someone isn't adequately considering the future. But just a person having high time preference, just being impatient, isn't in and of itself a problem, it could just be their character. 

David Beckworth: Well, let's leave that to the side. Let's just say there are these people who do have high discount rates, high time preferences. 

James Broughel: Also you might face high market interest rates. It might be difficult for you to borrow for example your credit constrained, and that could lead you to consume more in the present. 

David Beckworth: I want us to kind of start, imagine a world where we're building up from people, okay. So I'm going to build a nation full of Charlie Sheens, and I'm going to make a case that that actually can help contribute to what the market rate is if everyone's a Charlie Sheen, a nation full of Charlie Sheens. But in Charlie Sheen world, again, I'm sorry Charlie Sheen if you're listening out there, but you're going to be my example of someone who has a very high discount rate. So you're effectively saying you really discount the future if you’re Charlie Sheen in this case. What you're saying is, how you value the future in current terms, in present value terms, is low. If you take the future, you do all this activity, it's a statement that you're discounting it to a value that's not worth much in present value terms, the future. 

David Beckworth: Let's go to the other extreme. You've got someone who's very concerned about the future, very concerned about the future of the planet, of children. They're thinking very, very much about leaving the world a better place than the way they found it. And so, they have very different behavior than Charlie Sheen. I'm going to call this person Mother Teresa, okay? Mother Teresa would be someone who has a very low discount rate. They're not discounting the future, they're thinking very long and hard about where the future is going to be. So, for them, the present value of the future is high, very high because they're discounting at a very low rate. Is that a fair interpretation? 

James Broughel: Right, that's right. I think it's worth mentioning that just very small tweaks in the discount rate just because of the power of compounding can have big effects on the present value, especially of goods that are far in the future. 

David Beckworth: All right, so we got these two extremes here, and I'm just kind of, I'm overstating the case. You got your Charlie Sheens, you got your Mother Teresas. And let's pretend again, there's a country, one country is made up of Charlie Sheens. So Charlie Sheens, they're kind of living for the moment, they really discount the future, which probably implies they're probably not saving a lot, right? 

James Broughel: Right. 

David Beckworth: They're not saving a lot. There's going to be less funds available, less capital available. So rates are going to be pretty high because of the nature of how they behave, less savings, higher interest rates. So what you see is that high discount rate translates into a high market rate, all else equal. So ignoring productivity on capital, return on investments, all else equal, you'd see that, where a Mother Teresa world where she is saying for the future, you'd see more savings, you'd see lower market rates. So her lower discount rate translates into a lower market interest rate. Is that fair? 

James Broughel: It's hard to say, the causation kind of runs both ways. But yes, I think- 

David Beckworth: Kind of ceteris paribus. You're God, James, okay, and you create a planet of Charlie Sheens over here, you create a planet of Mother Teresas over there, you would expect all else equal. You'd see different market rates based on their different discount rates. 

James Broughel: Right. Market rates in an economy that's kind of well functioning should represent something about the time preferences of the population. There may be reasons why they don't, externalities, taxes, all kinds of things. 

David Beckworth: And we'll get to those in a minute, we'll get to those. So that would be a case where you can think through just for our listeners, how individual discount rates, how we value the future versus the present, kind of a weighted average or kind of added up, kind of an aggregate measure can influence what we actually observe in market rates. I have been saying ceteris paribus, there are other things. You mentioned market failures or transaction costs or taxes. I want to mention another one that, you know, I'm a macro economist and my focus is more on the business cycle side. And one of the things we often think about is the natural rate of interest, particularly what is it relative to what the Fed's doing. 

David Beckworth: And kind of a standard natural rate of interest definition that we think of comes from kind of a growth model, basic growth model, where the natural rate of interest is equal to this discount rate plus like expected productivity growth rate. That expected productivity growth rate might affect, for example, the return on capital and that may also, so in other words, you can think of a world where holding constant ones discount rate, changes in productivity growth rate could also change interest rates. So, there's different things influencing the ultimate outcome? 

James Broughel: Right. In kind of like a growth model world where it's a perfect economy, we're operating along an optimal growth path, then the market interest rate should also equal the social rate of time preference of the population, which tells you something about the rate at which this is the society would trade consumption today for consumption in the future. That should also equal the marginal productivity of capital. So that's kind of a foundational equality. 

David Beckworth: Those are both, in equilibrium, they're going to be equal and they're going to drive the market rate is what ... 

James Broughel: That's right. 

David Beckworth: Okay. And just trying to build up the basics here, that social discount rate is kind of the story I was telling you about the type of people you have and the marginal product capital is tied to the innovations, technology, those things, those are all influencing ... 

James Broughel: I think it's worth mentioning, though, that there isn't consensus that this notion of what we're talking about now is the social discount rate, that's the definition of it. There are many, many economists who believe that it is this kind of social rate of time preference, it's this aggregation of the time preferences of everyone in the community. But there are other economists who have kind of a different view of what the discount rate is so we can get into that. 

David Beckworth: Yeah, we will. But as you mentioned, in the kind of the macro setting, we look at what is the natural interest rate, that's the explanation I'd always give. You're right, they're going to be equal but they're both forces. So for example, an exogenous increase in productivity growth rate would all else equal lead to higher rates, and eventually, you know, all the rates would converge, it might be some adjustment up and down, it would converge. Or suddenly a sudden exogenous change in the type of people in a country, rates would eventually adjust to this new pressure created from that. 

David Beckworth: So I just bring those up just to really stress, you know, if there's a sudden increase in the growth rate of productivity, that makes the return on capital higher, so the marginal product of capital is higher, so people want to invest in capital which causes market rates to go up. So, there's these competing forces. And this leads us I think into the discussion of a social discount rate. I'm telling a simple story, and the social discount rate, depending, like you said, on who you ask, there's different stories behind it. 

David Beckworth: Before we get into this debate, and this is what your symposium is about, your symposium had three papers, you did one of them, there's two other papers we'll mention. And they have different ways of measuring or estimating or thinking about the social discount rate. But tell us why is this what has been up until now and academic discussion between you and me about the underlying interest rate, why does this social discount rate matter for policy? Why [are] there people paying you money here in Washington, DC to think about this, to go advise politicians about this, to correct others thinking on it? 

James Broughel: So, the social discount rate is an input in cost benefit analysis. And so cost benefit analysis is an analytical tool that policymakers and regulators in particular use to evaluate the positive and negative consequences that they expect their policies to produce. It's used especially for regulations, especially the biggest regulations, and in particular, social regulations, which are regulations related to health, safety, and environmental issues. And the social discount rate is an interest rate that's used in cost benefit analysis to convert all the costs and benefits which arrive at different moments in time into one present value. 

James Broughel: But as I mentioned, it can have, just small tweaks in the discount rate, it can have dramatic effects on the present value of costs and benefits especially when they're far in the future. So just as an example, there's a concept called the social cost of carbon, which is an estimate that the government has produced about what's the additional damage to the economy and the environment from emitting an additional ton of carbon dioxide into the atmosphere. So, the Obama administration estimated at a two and a half percent discount rate, it was about $71 a ton. So if we reduce a ton of carbon dioxide emissions from the atmosphere, provides $71 worth of benefit. And a five percent discount rate fell to $13 a ton. So, 71 is about five times maybe higher than 13. 

James Broughel: The Trump administration is now using seven percent discount rates, and so that number's fallen even lower. So the Trump administration has estimated that a seven percent discount rate, they're only counting domestic effects whereas the Obama administration considered global effects. So, the Trump administration says a sevent percent discount rate, the social cost of carbon is $1, and they say at a two and a half percent discount rate, it's $9. 

James Broughel: So, what this means is that this one input in cost benefit analysis can be almost the only factor that matters in determining whether some of the most important policies we're considering, like how to combat climate change, whether they pass a cost benefit test or not. 

David Beckworth: So just to reiterate this point about the varying discount rates. With the Trump administration using a seven percent rate, what that means, and correct me if I'm wrong here, is that they're saying, the present value of these feature benefits is much less in their view? 

James Broughel: That's right. Now, that could be interpreted as meaning that the future doesn't matter as much, and some people interpret that seven percent rate that way, that we're just saying the future isn't as important. Other people might interpret it as saying, well, we can expect high rates of return and if we just left money in an account, it would grow into some really big value in the future. 

David Beckworth: So it depends on the reasons for- 

James Broughel: It depends on the reason for a discount. 

David Beckworth: But one, let me say this, one potential interpretation is that I don't value the future as much as Obama did, that's what Trump is saying. I don't value the future. 

James Broughel: There's some people making that argument. 

David Beckworth: Some people are saying that Trump is being a Charlie Sheen here and Obama's being a Mother Teresa. But, there's other reasons, and to be clear, there's other interpretations to the higher discount, which could be maybe we think there's going to be greater technological gains, greater economic growth. We'll come to those. But just to flesh this out a little bit more, so you look at how much the present, how much is that future resource, that future value in today's terms. So, you look at the cost of carbon and you compare it to what would it cost us today to, there's some benefit in the future. 

James Broughel: Right, benefit in the future. 

David Beckworth: So you got to weigh, okay, this is how much in today's dollars, adjusted for the discount rate, in today's dollars, what it's worth to us, whatever you're doing in the future. And then let's look at the cost of making this policy change. And if it's positive, you go ahead with it, right? 

James Broughel: Right. That's the fundamental challenge, that we have benefits often that arriving in the far future, costs that are upfront, sometimes costs in the future, benefits that are upfront. And we need to figure out a way to compare them to one another meaningfully so we can make a decision now. I would also say that a cost benefit analysis shouldn't be the only factor that determines whether a project proceeds. So if the cost benefit ratio comes out above one, if the benefits exceed costs according to our cost benefit analysis, that may mean we should go forward. But we should also consider other factors like equity and fairness and human rights, and that all of these things come into the final decision about what to do. Cost benefit analysis is one input in that decision. 

David Beckworth: I guess this kind of begs a question about cost benefit analysis because you mentioned these other potential benefits or costs. It says to me, well, maybe we're not measuring the benefits properly, right? If equity, whatever the other issues, if you could put some kind of dollar number and all these other benefits and other costs and put them into one big equation, that would be the perfect cost benefit, right? But you're saying we can't. 

James Broughel: There's a lot of debate over how many things to include. Should we just look at the direct cost to businesses complying, the direct benefits to improve safety or health to a particular group? Or should we consider all the effects, the ripple effects? Sometimes these are called co-benefits or co-costs. And there's debate about how far to go because obviously, if you start considering the whole economy, the effect of one policy on a whole economy rather than just kind of a snippet of the economy, the uncertainty just grows dramatically. And so, it becomes much less clear about as to whether what you're saying is really very meaningful. 

David Beckworth: And even mentioning like environmental policies, but this idea and there's a term that's used, the net present value is positive. So you add up all the benefits, so that you hear this term, NPV or net present value, it's got to be positive, so it's got to be greater than the cost, in current terms. But this is often applied to example for like infrastructure projects and debates about that. And I had a previous guests on the show, we were talking about sports economics, talking about building stadiums, these big athletic stadiums. We have people at Mercatus, our colleagues working on this issue of sports stadiums. And they will often show how there's a huge cost to the local government, to local taxpayers, building these big, big stadiums relative to the benefits. 

David Beckworth: And most people I think both left and right typically agree that many of these sports stadium seem to be a boondoggle, they seem to be a great way to lurea professional team. And many would make the case I guess that the net present value is not positive, it's negative. I talked to a sports economist, he actually pushed back on that. He argued that with sports events, it's hard to capture the true benefit in dollar terms. So for example, if there's a great sports play. Now let's say it's a great pivotal moment and it's played over and over again in your mind for years and years to come, and the fans all rally around this important catch or this important score, there's value that goes on for a long, long time. And the true value of the stadium isn't reflected in just the revenue that's pulled in or the advertising. There's these intangible… it's almost like capital, there's these memories that people forever will want to hold on to. And so, it makes it difficult to do a true cost benefit analysis. 

James Broughel: A true cost benefit analysis won't just look at the financial effects of some policy change. It will really be concerned with anything that's impacting the utility of the citizenry of people. Now, it can be really hard to value things like a memory about a great sport event. In practice, I would say infrastructure-like projects tend to be more like just financial analysis where we're just considering how much are we spending and how much revenue are we going to generate. Whereas cost benefit analysis that the government does in the regulatory context will include things like lives saved and health improvements, and they'll try to value those things and put dollar values on them. 

James Broughel: And so, cost benefit analysis is really kind of broader than just financial analysis. But it becomes much more challenging once you start moving away from just the financial effects. 

David Beckworth: Okay. But government is supposed to be doing this cost benefit analysis, right? 

James Broughel: So, regulators in the executive branch are required to do it by, initially by an executive order that Reagan signed in the early 80s, and the current executive orders from 1993 from President Bill Clinton, they're required to do this for so called economically significant regulations, which are rules that are expected to have an impact of over 100 million dollars in a single year. So for the really big regulations, they're required to do a regulatory impact analysis. And part of that is a cost benefit analysis. 

James Broughel: I should say that in practice, you know, only a very small number of regulations really have a cost benefit analysis of maybe two percent or something like that. And it's probably closer to one third of one percent of regulations that actually have dollar estimates of costs and benefits. So, that's federal regulation. So, it's really only a very small number of the biggest regulations. 

David Beckworth: That's interesting. So, it’d have to be something very consequential. Let me throw out some examples, how about like elements of Dodd-Frank and financial regulatory. 

James Broughel: So, finance is interesting because most of the financial regulators or so called independent agencies historically, they've been considered outside of the scope of this executive order. So they haven't had to do cost benefit analysis. 

James Broughel: Now, the SEC lost some court challenges earlier in this decade and those court cases have led the SEC to kind of rethink whether maybe they should start doing this kind of analysis. And they start hiring some economists because they weren't really considering the costs and the effects on efficiency of their regulations. So, the SEC has begun to do more work along these lines. They're kind of decades behind. The so called executive branch agencies, which are agencies like Health and Human Services, EPA, Environmental Protection Agency, Department of Transportation, Department of Labor, these agencies have been doing cost benefit analysis for decades. 

David Beckworth: So they could borrow some wisdom and insight. 

James Broughel: So there's not much cost benefit analysis in the implementation of Dodd-Frank. 

David Beckworth: Okay. I was about to ask, my favorite agency that I do all on the Federal Reserve, are they doing much of this? 

James Broughel: No. I think almost universally no. There may be a handful of examples where they had to coordinate on some regulations with other agencies that are required to do it. But as a general practice, they don't do it. 

David Beckworth: Okay. And I imagine it's tough, like you said, in some cases, it's tough to do these, to truly incorporate all the benefits, all the costs. 

James Broughel: It's funny because cost benefit analysis, when it first started getting done a lot for regulations in the late 70s, early 80s, people said, you can do this for finance, but for environmental effects and for human lives and risk reduction, it's too hard. But now it's become most sophisticated in those areas, in those areas of social regulation. And there are people who say, well, it's too complicated for finance because we're trying to, we're trying to look at the effects on systemic risk and things like that. So, it can't be done for financial regulation. 

David Beckworth: Will be interesting to see. And I hope that we do see continued progress on that front. So you fight the good fight and keep pushing that even into the Federal Reserve's world. Okay, so let's get to your symposium on the social discount rate. There were three papers that were written. I want to begin with a paper by David Burgess and his title was, “The Appropriate Measure of the Social Discount Rate and its Role in the Analysis of Policies with Long-Run Consequences.” And he takes what you call a social opportunity cost of borrowed funds. So he looks at the weighted average of return on investment, postponed consumption, foreign funding. Tell us about this social opportunity cost approach to the social discount rate? 

James Broughel: Sure. So, just as background, there's kind of two main schools of discounting. One of this social opportunity cost approach, the other is a social time preference approach. The social opportunity cost approach tends to recommend relatively higher discount rates relative to the social time preference approach. So, David Burgess, I think, recommends a seven percent discount rate. So he would recommend that rate at higher rate that the Trump administration is using. But these two schools actually disagree on a lot. They disagree on more than just what number to use. They also disagree about what the function or the role of the discount rate is and analysis itself, which is obviously going to lead to disagreements about what number to use. And they even disagree about what cost benefit analysis is measuring. So they disagree about the welfare measure underlying cost benefit analysis. So this gives you a sense of like how much disagreement there really is in this issue. 

James Broughel: The opportunity cost school thinks of the role of the discount rate as representing a counterfactual state of the world, that we need to compare projects to in order to assess whether they're providing net benefits and costs to the world. So, they see the discount rate as kind of an interest rate that's this foregone rate of return in this counterfactual world. So that's somewhat different than what we were talking about earlier, where we were talking about it's kind of like an aggregation, a discount rate is an aggregation of the preferences of the population. 

James Broughel: The social opportunity cost world looks at it as something slightly different. Now the welfare measure that they're interested in considering is efficiency. So allocative efficiency, sometimes called Kaldor-Hicks efficiency, which basically just says, you know, are the gains in terms of wealth bigger than the losses in terms of wealth. So they just want to measure kind of social wealth, and they're not as concerned about the distribution of that wealth. And this is often a critique of cost benefit analysis and Kaldor-Hicks efficiency is that it just focused wealth but not as much on distribution. 

James Broughel: So the actual way that the social opportunity cost school estimates the discount rate is using a weighted average approach. In order to understand this approach, you have to introduce kind of two discount rate concepts, interest rate concepts. So one is, one's called the investment rate of interest. So this is the rate of return on private investments. You can think of it as like the rate of return in the marketplace or on the stock market or something like that. The other is something called the consumption rate of interest, which is this rate at which society would discount consumption or would trade consumption today, unit of consumption today for a unit of consumption in the future. That consumption rate of interest is usually thought to be lower than the investment rate of interest. 

James Broughel: So the social opportunity cost school is concerned with what are the resources that are displaced when we build that bridge or we build that school or whatever it might be. Some resources would be consumed in absence of our project, some resources would be invested and that would grow in some value at some rate. And so they say, the weights that they take are basically the proportions of project funding coming from consumption versus coming from investment. And so, the social opportunity cost school tends to look at market rates and use those to provide a basis for what the investment rate of interest is, what the consumption rate of interest is. 

James Broughel: OMB, the Office of Management and Budget, recommends two discount rates, seven and three percent, which I think can be interpreted as the investment rate of interest and the consumption rate of interest. 

David Beckworth: The official standard implicitly endorses the opportunity cost approach? 

James Broughel: I would say it's mixed. 

David Beckworth: Oh, it's a mix. 

James Broughel: It's pretty close to the opportunity cost approach. 

David Beckworth: It's leaning that direction. 

James Broughel: The opportunity costs approach would say, the true interest rate is somewhere between those rates. If we discount it both and a project passes a cost benefit test, we can feel pretty safe that the project really does pass a cost benefit test. Because the weights, basically, if half of the funding came from investment, half from consumption, and the three and seven percent are the right investment in consumption rates of interest, the true right might be five percent. But there's a lot of uncertainty about how much investment and consumption is actually displaced. So they would say, let's do this range. 

David Beckworth: So just to repeat what you've said and make sure I'm following, the social opportunity cost approach says, well, let's look at the money we're taking from consumption. We're collecting taxes, we're taking these resources. So people could be spending this on current consumption or doing something what they're going to saving, they have these funds that they're going to consume, we're going to take it away from them and we're going to take some away from investment opportunities. Let's consider what the consumers and the investors would have gotten out of it and then compare that to what we're going to do with the funds. And if what we're going to do with the funds is greater than the lost consumption, the lost private investment, go for it. 

James Broughel: Yeah. So they're basically saying, we're giving up some rate of return in this world without our project. So we should discount all the costs and benefits at that rate in order to account for what we've given up. 

David Beckworth: This approach, we'll get to the second one, is this approach easier to calculate than the one we're about to, the second one that ... 

James Broughel: I would say probably, yeah. 

David Beckworth: Because it is more concrete, you actually can just go out and find these opportunity costs. 

James Broughel: Yes. There are debates about so called descriptive versus prescriptive approaches to discounting. What this means is, should we kind of prescribe some rate as the consumption rate of interest or should we describe it using some market rate of interest. And the SOC people tend to be descriptive but there's no reason in particular why that would have to be the case. So this idea of a consumption rate of interest that society discounts consumption at some rate is obviously kind of a rather controversial assumption and uncertain assumption. And many people might argue that we shouldn't rely on market interest rates to select that rate. So SOC people tend to be- 

David Beckworth: SOC is the social opportunity cost. 

James Broughel: ... tend to be descriptive, but there's no reason necessarily they would have to be. It tends to be kind of a simpler approach but it could be made more complicated if you really wanted to dig into some of their assumptions. 

David Beckworth: Okay. So, what is your critique of this approach? I mean, you've mentioned some of that but tell us again and highlight what's the big challenge in using this approach? 

James Broughel: There's a fundamental assumption in this approach, which is that all benefits are just like cash. So, the SOC, the social opportunity cost approach accounts for what we give up when we embark in government projects. Some of it is consumption and some of it is investment. But they don't treat consumption investment differently on the benefit side of the ledger. So, $100 worth of consumption and $100 worth of investment would be discounted using the same rate as if they're growing over time at the same rate. 

James Broughel: So, this approach is really only a special case that applies in the case where the benefits from your project are all basically like financial benefits in terms of capital. So maybe that would apply, for example, in the infrastructure project, building the sports stadium where you're just concerned with economic activity and you're not going to, you're going to rule out any other kind of benefits. It might be okay to use this rate in that situation but it certainly would not be okay to use that rate in a case where you're considering lives saved in the future or health and environmental kind of benefits, because those benefits are not like cash. 

David Beckworth: Okay. And that's the big critique there, is they're making a strong assumption that the benefits are all cash equivalent. 

James Broughel: Right. 

David Beckworth: Okay. Let's move to the second paper in the symposium. And this is a paper by Mark Moore and Aidan Vining. And they take the other approach you've been talking about. And their paper title is The Social Rate of Time Preference and the Social Discount Rate. They maximize a social welfare function, they're trying to maximize our well-being or to compensate their utility, which is very different than kind of this whole trade off with the opportunity cost folks. They want us to be warm and fuzzy on the inside, right? 

James Broughel: Right. 

David Beckworth: So tell us about this approach. 

James Broughel: So they are obviously more concerned with distribution than the purely efficiency folks. So this approach tends to recommend relatively lower discount rates, maybe on the order of one to four percent. Sometimes they recommend rates that decline over time due to uncertainty in the future. They see the role of the discount rate as the social rate of time preference. It's this consumption rate of interest, the rate at which society would trade consumption today for consumption in the future. So it can be thought of as like an aggregation of the preferences of everyone in society. 

James Broughel: And the welfare measure that they use is a social welfare function that they derive from the Ramsey neoclassical growth model, which is a famous economic growth model. So they take a welfare function from that model, they say this is society's preferences or this is the social planner's preferences or something along those lines. And then their goal is to maximize that. This approach actually has some significant advantages in some ways over the social opportunity cost approach. And it works in two steps. The main advantage is that they've looked at this problem that we need to somehow distinguish between investment related benefits and consumption related benefits and investment related costs and consumption related costs. That was the problem that the social opportunity cost approach kind of struggled with. And they came up with a solution to that. 

James Broughel: They said, first, let's just convert everything to equivalent units of consumption. Let's convert all the investment related benefits to units of consumption, let's convert all the investment related costs to units of consumption. Then everything is in consumption terms. And they do that using a device called the shadow price of capital, which is basically a conversion factor. Then they discount at the social rate of time preference. So essentially, they believe that the proper way to account for the opportunity cost of capital and analysis is not through discounting, it's through shadow prices. It's through the shadow price of capital device. And so, that's how they get around that problem that rose with the social opportunity cost school. 

David Beckworth: So just to make this clear in my mind, the social opportunity cost which they're critiquing kind of looks at the raw benefits derived from investment, consumption tradeoffs that you're taking away. And what this approach is saying, look, you got to actually take those dollars and put them into the value they create in terms of welfare. And on an even playing field, you got to compare apples with apples and apples with orange, and look at how people, give me some strong assumptions about what welfare is all about. That's another I guess critique it would be, how do we actually know what is true social welfare. But assuming you know that, they're actually doing at least a consistent job making a welfare comparison, where the other folks are like, let's just get the net present value in terms of dollars. 

James Broughel: I think that both schools are concerned with real resources. So, economists should think about cost benefit analysis as measuring real resources, even though we put in dollar terms, it's real dollars, you know, that represents, you could think of it as apples or whatever it might be, we're counting everything in apples. The social time preference method is more formal in that they kind of convert everything into apples, then they put apples in their social welfare function and then they let that tell them what produces the most utility for society. 

James Broughel: The social opportunity cost method is just kind of cruder. It's more administratively simpler. It's kind of like a rule of thumb in a way. 

David Beckworth: Okay. I'm getting the sense that the social opportunity cost is what we do in government because it's easier. And the academics say, no, no, no, you need to use time preference approach. 

James Broughel: That's right. 

David Beckworth: But again, just again, to stress this point, this current approach we're talking about the social rate of time preference approach, it's actually looking at the distribution across time, right? There's the future generations, do we care about them more, do we care about us more? Where the social opportunity cost is kind of, what's the best bargain today, what's the best trade off today between investing with, the private sector investing, households investing versus us taking on this project and government, it's a trade off ... 

James Broughel: Yeah. You could have a strange situation where under the SOC method, if you just left resources in the economy, they would grow to some value in the future. If your benefits were less than that, it would fail a cost benefit test unambiguously. The social time preference method, you could have a situation where that isn't true, where essentially, you could just leave resources in an account and it might grow into a value that's some value in the future. But your benefits are lower than that but that's okay because it provides more utility. 

David Beckworth: Interesting. So the social time preference approach cares more about distributional equities you mentioned, future generations versus the present. But one of the things I found interesting reading these papers is they actually discount the future more if I understand correctly because they're going to be wealthier in the future. Let me read a quote to make sure I got this right. It says, “Given the assumption of diminishing marginal utility of income, so each additional dollar is less than less valuable to you, the consumption of wealthier future society should be discounted.” 

David Beckworth: So, on one hand, they're concerned about this distributional equity, but on the other hand, they're making this assumption, well, good grief, those future generations are so much wealthier than we are that we should like consider that too. We're poor considered to the future generations. So on one hand, they talk of progressive talk. On the other hand, it seemed very unprogressive what they were saying. They're like ... 

James Broughel: If you're going to be logically consistent, if you think today, we should redistribute from the rich to the poor, you should also think across time, we should redistribute from the rich to the poor, and they are consistent in that regard. They think that we should discount the welfare of people in the future. Well, in this case, the consumption of people in the future because it provides less welfare because they're going to be richer. So, there's this inequality aversion parameter that enters their social welfare function that says, society's inequality averse. It doesn't like it if people in the future are way richer and consume way more than people today. So we should discount their consumption a little bit and consume a little bit more today in order to account for that. 

David Beckworth: Okay, so they are being consistent. I was wrong. I take it all back. All right, so what is kind of their bottom line number? We had seven percent for the other group, for the social opportunity costs. What do the time preference folks want or see? 

James Broughel: In the essay for the Mercatus Symposium, I think they settle on three and a half percent and they recommend a discount rate that declines over time for projects with kind of long-run intergenerational effects. And that basically that just has to do with inequality or uncertainty, I'm sorry, and assumptions about risk aversion on the part of society. Again, it relates to assumptions kind of built into their social welfare function. 

David Beckworth: Okay. Your critique of this approach. 

James Broughel: Well, the most obvious problem with this approach is that it relies on this social welfare function, which is supposed to describe the aggregated preferences of everyone in society. And aggregating the time preferences of everyone in society is really just a special case of aggregating the preferences in general, which runs into this issue of Arrow's Impossibility Theorem. 

David Beckworth: Explain that for all our non-economists out there. 

James Broughel: It's generally argued that with a few basic assumptions, like we don't allow one person to be the dictator that rules over everyone else in society. That there is no social welfare function that describes the aggregated preferences of everyone in society, that you actually just can't aggregate up the preferences of everyone. What the social time preference people do is they take this representative agent in this macroeconomic model, this Ramsey model, and they just assume that his preferences, that's a model where it's one agent or one household and everyone's assumed to be the same. And they just say, well, that's society's preferences. And this has become a convention in economics, it's done all over the place. 

David Beckworth: Because it's tractable, right? It's easy to do. The math is easy. 

James Broughel: Yeah, you can do the math. But, there really isn't any basis for it. I think that they would, the advocates of this approach would acknowledge that. They would say, our approach is normative, but hey, lots of economists agree on it. So, this is our method and we like it. And they aren't concerned with efficiency. Efficiency, like we said- 

David Beckworth: Allocative efficiency. 

James Broughel: Allocative efficiency is kind of indifferent to the distribution of wealth. They don't like that. Efficiency depends on the initial distribution of wealth too. So the efficient outcome will depend on what the initial allocation of resources is. And so, they prefer the social welfare function approach to just being guided by efficiency. 

David Beckworth: Okay. Which leads us to your solutions. So you had this industry symposium and you have the grand solution, we've been waiting the whole show to hear. So tell us, James, what is the solution in your view? 

James Broughel: So, you know, first of all, I would say that I don't necessarily accept everyone to endorse my view, but I think that we should all recognize that there are some conceptual problems with both of the standard approaches. It's troubling. It's troubling to the point that it's not entirely even clear what cost benefit analysis is measuring. This has been going on for decades. 

James Broughel: Now, my own perspective is, I would like cost benefit analysis to be based on the Kaldor-Hicks criterion, to be based on this notion of allocative efficiency. And my view is that this idea of the consumption rate of interest is actually incompatible with cost benefit analysis, measuring efficiency. And that's because at its core, what it does is it makes interpersonal comparisons of utility between people today and people in the future. We're saying that consumption to a person today is worth more or somehow than the same amount of consumption to people in the future. 

James Broughel: And the whole idea of Kaldor-Hicks efficiency was created to get around this issue of interpersonal comparisons of utility. If John eats an apple and Sally eats an apple, who gets more utility from it? Economists don't really know. Even if John started with more apples, it's not really clear. Maybe he just loves apples and Sally doesn't even like apples. So Kaldor and Hicks basically said, well, let's just measure wealth, let's just count apples and leave it to someone else to decide what the right distribution of wealth is. That's not to say that distribution doesn't matter. It's just, it's separate from the analysis of efficiency. My view is cost benefit analysis should measure efficiency and then we should separately consider maybe through cost benefit analysis looked at particular groups, subgroups, these distributional effects. 

James Broughel: My recommendation is to simply remove this consumption rate of interest from cost benefit analysis and not discount consumption, just so that, we're just assessing the overall amount of wealth and we're indifferent between who gets the wealth including across time. That recommendation is even inconsistent with the social opportunity cost perspective who claim that they're measuring efficiency but they still use this consumption rate of interest. So my argument is it's inconsistent with efficiency, and so we should drop it. 

James Broughel: Now, that said, I think that the social time preference approach is essentially right in how they deal with opportunity cost of capital in that they use a shadow price and they convert all units of capital into equivalent units of consumption using the shadow price of capital method. So I think we still have to do that, we shouldn't ignore opportunity cost, but that we shouldn't discount after that. 

David Beckworth: What does that leave us with? So there's a lot packed there, we've got a little bit of time left. I encourage our listeners, if you're interested in this to go look at the papers we'll have online. But what does your conclusion mean in terms of a discount rate? 

James Broughel: So, my conclusion means I believe it's correct that the social time preference school is correct in their interpretation of the discount rate as this social rate of time preference. But my view is that the only rate that's consistent with efficiency is zero. And so, what that essentially means is that we should try to grow consumption as much as possible. We should try to maximize efficiency. So the optimal growth path for the optimal amount of social welfare that we would arrive at under my approach is consistent with kind of the golden rule rate of economic growth, the rate that maximizes consumption. 

James Broughel: So, the social time preference people want to grow slower than that rate because they're concerned about distribution. But my recommendation is, let's leave those issues of distribution out of cost benefit analysis and just grow at the rate that maximizes consumption growth, which is more essentially this golden rule rate of economic growth. 

David Beckworth: Okay. What does that mean, though, in terms of like this present value equation? Can I plug in zero to the denominator of present ... Are you saying then that you're valuing the future in the same equal terms as the present? 

James Broughel: Everyone gets equal weight, that's what I'm saying. Everyone gets equal weight. There's an economist named David Levy at George Mason University. He likes to talk about analytical egalitarianism. There's a long history of this in the economics profession. That in our analysis, if you're included in the analysis, you get treated equally. We don't apply some kind of weight on you to say you're worth less or your consumption is worth less than others. So, I want to stick with that principle of analytical egalitarianism and give everyone equal weight. 

David Beckworth: Whether they're in the future or in the present. 

James Broughel: Whether they're alive or whether they haven't been born yet, whether they're alive today, they get equal weight in the analysis. 

James Broughel: Now, that does create some complications as you mentioned because the shadow price of capital is actually dependent on this social rate of time preference because the value of capital, what should we say the value of capital is if the returns from it could essentially be reinvested in perpetuity forever? Well, essentially, it's infinite. But that's actually not really very different from the social opportunity cost perspective, which said, well, we're giving up some rate of return indefinitely into the future. That's how they view the discount rate. What I'm saying is that what they're thinking about is the discount rate is more accurately thought of as the interest rate in the shadow price of capital formula. It's the growth rate of the value of the consumption stream that capital will generate into the future, and that that will yes go towards infinity in the indefinite future. So, that creates some issues because all of a sudden, there's a lot of infinities in your cost benefit analysis. 

David Beckworth: And what about like climate change? What would this mean in real terms for climate change? 

James Broughel: The way that we would, in practical terms evaluate projects, and Tyler Cowen, who's a professor here at George Mason as well has influenced my thinking on this a lot, is that we would evaluate projects based on the rate of return to capital based on this interest rate or this growth rate in the shadow price of capital formula. So capital really becomes the dominant factor in analysis and consumption because it's kind of fleeting and temporary, tends to play smaller role. It's not to say that we should not consider it all. It's just that it's not growing or compounding in value in the same way. It doesn't have the potential to produce compounding benefits in terms of utility for the citizenry. 

David Beckworth: Let me reframe my question. And I think of the zero discount rate, so I'm thinking of, again, like climate change regulatory policies. What that tells me is that you're really valuing the future generations or they're getting a lot of weight compared to what they would with the seven percent discount rate, right? So that means, I mean, you're actually putting relative to current formulations, current positive discount rates, you got a zero, which means you're giving more weight to the future than current. 

James Broughel: Yes. I am, absolutely. So current methods give a lot of weight towards present consumption over investment and give way to just the present in general well-being over the future. So I want to give people in the future equal weight. 

David Beckworth: So this would actually call in some cases for tighter regulatory policies. 

James Broughel: It could. I'm not going to take a stance on whether my approach would endorse particular policies, especially related to climate change. But it also suggests that small costs today will grow into something big in the future. 

David Beckworth: All right, well, with that our time is up. Our guest today has been James Broughel. James, thank you for coming on the show. 

James Broughel: Thank you. 

David Beckworth: Macro Musings is produced by the Mercatus Center at George Mason University. If you haven't already, please subscribe via iTunes or your favorite podcast app. And while you're there, please consider rating us and leaving a review. This helps other thoughtful people like you find the podcast. Thanks for listening. 

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