Deficits and Discounting

It is good to see the fiscal policy debate ramping up in advance of the December budget. One aspect of the debate that has received a good deal of attention – not least from the Minister for Finance himself – is the problem of compounding debt service costs. This concern is understandable given the scary arithmetic involved. But it is not something usually emphasised by economists and I think is distorting the debate.

The reason is the standard one of discounting. To be more concrete, suppose that we are considering a debt-funded lowering of taxes this year by €1 billion to be paid for by increased taxes in five years time. Assuming a real interest rate of 5 percent, the €1 billion compounds to $1.28 over five-year period. But the present value of $1.28 billion 5 years from now is just €1 billion (using the same real interest rate to discount future cash flows). In other words, the compounding and the discounting are a wash. In five years time we may very well look back and wish we hadn’t accumulated the extra debt. But that doesn’t change the appropriateness of using the discounted cash flow when deciding on the optimal fiscal strategy today. I doubt if any economist would forget to discount the future benefits from a public capital expenditure programme; but such forgetting seems surprisingly common in the fiscal policy debate.

There is a long and distinguished debate in economics about the appropriate way to discount the future, most recently (and heatedly) in the debate on the required policy response to climate change. Nicholas Stern in particular has argued against discounting using market rates where policies have effects over many generations. But I think it is fair to say that most economists support the conventional approach using market rates, at least as it applies to shorter-term decisions.

Of course, there are a number of good arguments for front-loading deficit reduction in coming budget, many of which have been made by Philip Lane in his recent posts. These include the effects on the risk premium, on expectations, and on optimal tax smoothing. Against these is the core Keynesian argument that the fiscal multiplier is higher today than it will be later if we believe the economy is operating below potential today. Identifying the optimal fiscal policy requires solving a difficult dynamic cost-benefit calculation with highly incomplete data. But the debate will be better served if we focus on the real elements of the calculation rather than the red herring of compounding debt service costs.

9 thoughts on “Deficits and Discounting”

  1. @John
    Excellent post. Our problems will not be over if we get the deficit under control and reducing the deficit too quickly will add to our problems. We need to start looking at ourselves like an economy on the Gold Standard.
    At that time the worth of a policy was judged by the resulting increase in national misery with frequently counter-productive results. We shouldn’t make the same mistake.
    What we should do is:
    Spend the Nama €5 Billion on capital infrastructure, the more employment the better. We need shovels in the ground. Spending on more residential/office/retail is wasted.

    Deregulate and cartel break, public and private.

    Cut average private sector and public sector wages, perhaps by 9%. We need to get our wages costs down and waiting for the market to do it will cause years of mass unemployment.
    Better to do it quickly and for good, then slowly and with no end in sight.

  2. On second thoughts 15% of GDP and 17% of GNP are just too high. We need to fully implement McCarthy, cut wages across the board and jack up taxes, especially for the very rich. As Lenihan is distressed by 63% that is probably a good rate to start looking at.

  3. “Spend the Nama €5 Billion on capital infrastructure”

    Is it possible to get this done without being swamped with accusations of once again “bailing out the developers”?

  4. @ John
    “I doubt if any economist would forget to discount the future benefits from a public capital expenditure programme”

    True indeed assuming the capital expenditures are genuine capital expenditures, metro, airport terminal or gas pipeline. Projects that could potentially pay for themselves by generating future discounted cash flows and even these may have to be postponed.

    However, serious problems arise, when the debt incurred is not used for capital expenditure. It is a casual norm in Ireland to borrow for current expenditures such as salaries, pensions and other benefits. It breaks all the rules of prudent economics. You would not get away with it in Leaving certificate economics.

    Furthermore, what happens if capital expenditures are incurred and out debt compounded because a government have a belief or a haunch? As in, borrowing short for NAMA to plough billions into finishing off risky projects in the “hope” that they will be salable in the future when we know that no one would touch them with a barge pole today!

    What happens, if they cannot be sold and must be held while debt servicing takes place over an extended time frame at rates of say 3% or 3.5% which is the 10 year rate envisaged by the ECB? Is it not common sense, that Increasing the supply of buildings and selling them or holding them over the market, will simply have the effect of reducing selling prices of All property across the state being offered in a particular class, residential or commercial. NAMA will drive solvent developers, and god knows they are scarce, into bankruptcy.

    The tendency is always to borrow from the future. Our politicians do it because they will not be in office to face the consequence. Does anyone expect Lenihan to be around after the next election? Alternatively, they do it simply to suspend reality for another year or two.

    Is it not time, for our generation to just grow up. To stop being totally selfish. To stop gambling and loading down future generations with our stupid and unjustifiable borrowing schemes? Is it too much to ask, that we pay ourselves out of the wealth that we generate as opposed to the “wealth” other countries generate.

    We are good at muttering platitudes about our young people then we go and betray them over and over. In the very near future we are going to have to answer to them.

  5. It is approved policy to keep Ireland weak. This is a policy that reduces strategic threats to Britain. Everyone benefits by exporting our children abroad. It is a tradition that is 170 years old. It is a success for British policy. As we have made it a part of our structural life, it is always available as a real but publicly lamented policy fallback position.

    When the population was increasing, it was uncontrollable and disruptive to all life and the economy albeit profitable and positive in some ways. We simply could not handle success. We invited in others to take lowly positions. We increased social welfare.

    Normal service should be resumed. Keep public pay low and encourage emigration by reducing social welfare rates to the levels of our neighbours.

    But perhaps we should plan for what we can do when we stabilize our economy? Where should we invest? Schooling so that other countries can use our graduates seems wasteful. Now is a good time to tease out what is our main reason for failing to take the best decisions. Corruption is a definite cause of poor decision making. Treating banking as a legitimate activity that can do nothing but good is another. Any others?

  6. @ Pat Donnelly
    “Now is a good time to tease out what is our our main reason for failing to take the best decisions.” We know the reason is corruption and crony insider capitalism.

    One example. When commenting on the proposed NPRF bill, Philip Lane and a colleague observed as far back as 1998 that “we would go further and preclude the fund from holding Irish assets.”

    Later in 2000, Patrick Honohan and Mr. Lane said, in another IT article titled, ‘Where Pension Bill Falls Down’ that, “most of the fund should be in foreign assets” …. “if the risk is to be diversified during an Irish economic downturn we would be badly hit”. But politics and crony capitalism trumped yet again. NAMA will be a carbon copy and worse of this rot.

    How badly hit are we now? Small wonder Moody’s are downgrading us yet again. The NPRF has been raided by politicians to prop up insolvent banks and the Fund is decimated. We still have a contingent liability of 100bn for pensions. This is the idiotic way we do business in this country.

    “Normal service should be resumed” The problem is that normal service is not working any longer and maybe that will be our savior. Have we educated them too much are they are getting above themselves? You seem to be saying, that sending them abroad with third level qualifications is wasteful. Are you saying teach them to read and write, hand them a packet of raisins and peanuts and a ticket to the UK?

    Are you saying, the cheek of them expecting to get a job and live in “our” country? Please expand your ideas, I’m fascinated.

  7. I think the obvious oversight here is when you have compounding issues that affect the assumed discount, I’m all for discounted cashflows to give a NPV equivalent, but if (as per yesterday) our nation is written down (two steps this time by Fitch) you have an external impact on debt servicing, granted this time it only increased our bund spread a couple basis points – but the fact remains, the debt itself isn’t the killer, its the downward trajectory/spiral that is hard to get away from, if massive deficits were not an issue every country would always be o.k. but historically you reach a certain debt burden (and high unemployment doesn’t bode well for output to repay bills with) and then things go bang. we are not special here, we are not different.

    in a nutshell, i don’t think the issue is that deficits are not discounted, it is more that the risk inherently increases as they get bigger and that can be an accelerator of itself causing secondary problems and you can’t discount those in the same way as a project. much like any lending bonds are underwritten in the here and now, not on future expected cashflows (although grading obviously has a future cashflow implication)

  8. Karl,

    Fair point. I should have been clearer. I do see the adverse impact of an increased debt on the risk premium as a real cost. I refer to this — admittedly opaquely — in the last paragraph of the post. I was really commenting on the much cruder argument, which I see as surprisingly common, that debt is bad because it has to be paid back with interest. This involves disregarding normal discounting procedures, and by extension normal cost-benefit analysis is set aside.

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