Tag: Tyler Cowen

Hurdle Rates for Public Infrastructure and Private Investment: How Low Should We Go? Under 2% Real in Normal Times, and Still Lower Now

Posted on by Brad DeLong

Matthew Yglesias tweeted:

I responded:

Then Matt challenged:

And I think: Gee, if I rise to this, like a moth to the flame, then Chris Shea of http://vox.com–to whom I owe 3000 overdue words on trade, manufacturing, politics, NAFTA, China’s accession to the WTO, and TPP–will be really annoyed that I am letting Matt Yglesias be a higher priority assignment editor than him.

I need to lie down until the desire to respond to Matt goes away, and then get up on things that have, you know, deadlines in the past…

Didn’t work…

Forbidden Planet Images of Krell Technology

We have a pretty good theory of how we ought to make decisions under uncertainty. It is, in fact, the same as our pretty good theory of how we ought to make decisions for society as a whole…

Let’s take the individual-uncertainty version first:

We exist behind a veil of ignorance: We do not know what the future will bring. We can, say, slice the future into 10,000 different 0.01% probability chunks, in each of which we would be different. Maybe only one of those 10,000 will actually happen, and the rest are unreal shadows produced only by our ignorance. Maybe (this is version I prefer) all 10,000 of them “exist” and will “occur”, as they are different branches of the quantum wave function of the multiverse, with each having wave-function amplitude that is the appropriate complex square root of 0.0001. (But the answer to the question of which appears to be unknowable. And which is “true” makes no difference.)

In deciding to take action X today, we are, given the uncertainties, doing something to benefit some of our 10,000 future selves and penalize others. We have some sort of obligation to our future selves, either because it makes us happy to sacrifice some of our present comfort for the sake of our future selves or because we wish to be people who are not total a–holes. (Again, it makes no difference.)

Do we take action X?

The economists’ theory tells us that if the effects on our 10,000 future selves generated by action X are unsystematic–if the variance of the effects over our 10,000 future selves is of the kind that can be diversified away–we should just care about the average effect. Thus we should take action X if the average effect is such that we would judge it worthwhile if we knew that the average effect would occur with certainty.

The economists’ theory further tells us that if the variability of the effects on our 10,000 future selves is systematic–that it tends to make those of our future selves who are relatively poor even poorer, and those who are relatively rich even richer–then we should aggregate the effects on our 10,000 future selves with an egalitarian bias: It makes little difference to our aggregation calculation if action X takes an extra dollar away from a future self with a lifetime income 90% and gives one to one with 110% of the future-self average. But by the time the consequences of our actions are taking wealth away from future selves with 30% and giving them to future selves with 170% of the average–then we need to incorporate a risk premium into our calculations.

And here comes punchline one: The effects of government interventions in infrastructure are about as systematic as are corporate business investments. The two, after all, are very strong complements. If the value of private sector goods produced is lower, the value of the infrastructure that enables the efficient production of those private sector goods is lower as well. If the value of infrastructure is high, that can only be because it is greatly assisting in the production and distribution of high-value goods. Tyler is right in asserting that the hurdle rate for government infrastructure and private sector investments should be roughly the same.

But–and here comes punchline two–Tyler goes wrong in asserting that the price charged by savers to fund private sector corporate investments is the right price from society’s point of view, and the price charged the government for borrowing is the wrong price to use to calculate the common hurdle rate for public infrastructure and private investments

Think of it: Neither government investments in infrastructure nor private sector investments in physical capital are that systematic as far as their risk his concert. And, at least on the scale at which we are currently investing, we are much closer to the 90% – 110% case than to the 30%-170% case. The average return required should therefore be governed by:

  • pure time preference,
  • the speed with which are wealth is increasing, and
  • the degree to which increasing wealth satiates us.

I see few signs that we are at the stage where increasing wealth satiates us to any strong degree. The speed with which our wealth is increasing is a per capita rate of about 1.5% per year. And as for pure time preference–well, from a social choice point of view, such a thing can only be irrational myopia. Your future self has the same philosophical and moral standing that your present self does: there is no compelling reason to prefer the interests of the one over the interests of the other. There is force majeur–your present self is here and now and has its mits on the stuff and controls what happens–but that is not a principal of moral but rather of immoral philosophy. In fact, there is an evolutionary-morality point working in the other direction, if you believe in any form of evolutionary morality. (You don’t have to.) Just because your present self happens to come first and time does not produce a moral principle that the interests of later-comers should be sacrificed to its selfish hedonistic pleasures.

Thus I, at least, find there to be a very strong and not yet refuted by anyone case that the presumption should be for a very low hurdle rate, from a social choice point of view at least. That low hurdle rate should apply to both government infrastructure and to private corporate investments. Claims that a higher hurdle rate is in some sense optimal or appropriate seem to me implausible, and to require very hard argumentative work for plausibility that has not yet been done.

What is this hurdle rate? I think you have to start from the rate of growth of per capita income, and make adjustments up and down from there: 1.5% per year in real terms. That is punchline two.

Why, then, does the financial system of a modern capitalist market economy grind out not a 1.5% per year real interest rate for risky private corporate investments? Why does it grind out a 5% per year rate for β=1 investments? Good question!

In my view, the answer is threefold. The market grinds out a wrong 5%/year rather than the right 1.5%/year because:

  1. Modern capitalist financial markets do a horrible job at mobilizing the potential systematic risk-bearing capacity of society as a whole.
  2. Modern capitalist financial markets singularly fail to solve the enormous moral-hazard and adverse-selection asymmetric-information problems involved in trusting your money to Steve Ballmer or Jamie Dimon–let alone Dick Fuld. (Cf.: Noah Smith.)
  3. We have brains design by evolution to do three things: calculate (a) whether the fruit is ripe; (b) whether it is safe to leap to the next branch, and (c) whether we should and how best to amuse men (women) so that they might mate with us. We do not have ranged can reliably make complicated and appropriate moral-philosophical calculations under conditions of great uncertainty and ignorance.

But that modern private capitalist financial markets are ridden by market failures of human psychological myopia, institutional map-design, and asymmetric information–and thus use the wrong hurdle rate–provides no reason at all for using the wrong hurdle rate when solving the public-sector part of the societal-welfare optimization problem.

Moreover, I have a punchline three: The argument as I have made it so far is a very general argument. It creates, in my mind at least a very strong and so far unrebutted (but possibly, with sufficient very hard intellectual work, rebuttable) presumption that the appropriate real hurdle rate is an expected return of less than 2% per year.

But ever since 2005 or so we have been in a very unusual time. For a large number of poorly understood reasons, the world has been awash in savings and yet short of investment. The appropriate hurdle rate has thus been less than the one established by the general argument. We are still in an unusual time. The U.S. labor market no longer has large obvious amounts of slack, but as the Paul Krugman with his Krell-like brain points out, considerations of asymmetric policy risks and global rather than local macroeconomic balance strongly suggest that the right policy is to still act as though the U.S. still has large obvious amounts of slack, and so needs to penalize saving and encourage investment at the margin by more than it is currently doing.

Must-Read: Paul Krugman: I do not think that word…<

Posted on by Brad DeLong

Must-Read: When did the default definition of “expansionary fiscal policy” become not (1) “the government hires people to build a bridge”, but rather (2) “the government borrows money from some people and writes checks to others, thus raising both current financial assets and expected future tax liabilities”? Or, rather, for what communities did it become (2) rather than (1), and why?

Or, perhaps, when did the deficit become the off-the-shelf measure of the fiscal-policy stance, rather than some other measure that incorporated some role for the balanced-budget multiplier?

This is something I really ought to know, but do not. It is bad that I do not know this:

Paul Krugman: I do not think that word…: “…means what Tyler Cowen and Megan McArdle think it means…

…The word in question is ‘spending.’ Tyler’s latest on temporary versus permanent government consumption clarifies… the confusion…. By ‘government spending’… I mean the government actually, you know, buying something–say, building a bridge. When Tyler says

The Keynesian boost to aggregate demand arises because people consider the resulting bonds to be ‘net wealth’ even when they are not,

the only way that makes sense is if he’s thinking of a rebate check. If the government builds a bridge, the boost to aggregate demand comes not because people are ‘tricked’ into feeling wealthier, but because the government is building a bridge. The question then is how much of that direct increase in government demand is offset by a fall in private consumption because people expect their future taxes to be higher; obviously that offset is smaller if they think the bridge is a one-time expense than if they think there will be a bridge built every year. That’s why temporary government spending has a bigger effect…. I guess there’s an alternative theory of what Tyler is talking about–maybe he doesn’t consider the wages of the bridge-builders count, that only what they do with those wages matters…

Or, rather, that all government expenditure is wasteful, and you might have well have simply handed out checks rather than forced people to engage in pointless useless make-work.

Cracking the Hard Shell of the Macroeconomic Knut: “Keynesian”, “Friedmanite”, and “Wicksellian” Epistemes in Macroeconomics

Posted on by Brad DeLong

The very-sharp Tyler Cowen gets one, I think, more wrong than right. He writes:

Tyler Cowen: What’s the Natural Rate of Interest?: “I… find all this talk of natural rates of interest…

…historically strange. A few points: (1) David Davidson and Knut Wicksell debated the… concept very early in the twentieth century, in Swedish…. Most people believe Davidson won…. (2) Keynes devoted a great deal of effort to knocking down the natural rate of interest…. There could be multiple natural rates… [or] no rate of interest whatsoever…. (3) In postwar economics, the Keynesians worked to keep natural rates of interest concepts out….

(4) The older natural rate of interest used to truly be about price stability… [not] “two percent inflation a year.”… (5) Milton Friedman warned (pdf) not to assign too much importance to interest rates…. (6) When Sraffa debated Hayek and argued the natural rate of interest was not such a meaningful concept, it seems Sraffa won…. (7) I sometimes read these days that the “natural [real] rate of interest” consistent with full employment is negative. To me that makes no sense in a world with positive economic growth and a positive marginal productivity of capital….

Of course economic theory can change, and if the idea of a natural rate of interest makes a deserved comeback we should not oppose that development per se. But I don’t see that these earlier conceptual objections have been rebutted, rather there is simply now a Kalman filter procedure for coming up with a number…. In any case, this is an interesting case study of how weak or previously rebutted ideas can work their way back into economics. I don’t object to what most of the people working on this right now actually are trying to say. Yet I see the use of the term acquiring a life of its own, and as it is morphing into common usage some appropriately modest claims are taking on an awful lot of baggage from the historical connotations of the term…

In my view, all (7) of these are more than debatable. For example, (7): “[That] the ‘natural [real] rate of interest’ consistent with full employment is negative… makes no sense in a world with positive economic growth and a positive marginal productivity of capital…” misses the wedge–the wedge between the (positive) expected real rate of return from risky investments in capital and the (positive) temporal slope to the expected inverse marginal utility of consumption, on the one hand; and the (negative) equilibrium real low-risk interest rate, on the other hand.

In a world that is all of a global savings-glut world with large actors seeking portfolios that provide them with various kinds of political risk insurance, risk-tolerance gravely impaired by the financial crisis and the resulting deleveraging debt supercycle, moral hazard that makes the remobilization of societal risk-bearing capacity difficult and lengthly, and reduced demographic and technological supports for economic growth, it seems to me highly plausible that this wedge can be large enough to make the low-risk ‘natural [real] rate of interest’ consistent with full employment negative alongside positive economic growth and a positive marginal productivity of capital.

And the bond market agrees with me in email:

Graph Long Term Government Bond Yields 10 year Main Including Benchmark for Germany© FRED St Louis Fed Graph 10 Year Treasury Inflation Indexed Security Constant Maturity FRED St Louis Fed

And (2): “Keynes devoted a great deal of effort to knocking down the natural rate of interest…” Indeed he did Keynes saw the natural rate of interest as part of a wrong loanable-funds theory of interest rates: that, given the level of spending Y, supply-and-demand for bonds determined the interest rate. Keynes thought that people must reject that wrong theory before they could adopt what he saw as the right, liquidity-preference, theory of interest rates: that, given the level of spending Y and the speculative demand for money S, supply-and-demand for money determined the interest rate.

I think Keynes was wrong. I think Keynes made an analytical mistake.

Hicks (1937) established that Keynes was wrong when he believed that you had to choose. You don’t. Because spending Y is not given but is rather jointly determined with the interest rate, you can do both. Indeed, you have to do both. Liquidity-preference without loanable-funds is just one blade of the scissors: it cannot tell you what the interest rate is. And loanable-funds without liquidity-preference is just the other blade of the scissors: it, too, cannot tell you what the interest rate is. You need both.

More important, however, in thinking about our present concern with the natural (“neutral”) (“equilibrium”) real rate of interest is knowledge of the historical path by which we arrived at our current intellectual situation. Alan Greenspan did it. On July 20, 1994, Alan Greenspan announced that the Federal Reserve was not a “Keynesian” institution, focused on getting the volume of the categories of aggregate demand–C, I, G, NX–right. He announced that the Federal Reserve was not a “Friedmanite” institution, focused on getting the quantity of money right. He announced that the Federal Reserve was now a “Wicksellian” institution, focused on getting the configuration of asset prices right:

Alan Greenspan (1994): Testimony before the Subcommittee on Economic Growth and Credit Formation of the Committee on Banking, Finance and Urban Affairs, U S House of Representatives, July 20: “The FOMC, as required by the Humphrey-Hawkins Act…

…set[s] ranges for the growth of money and debt…. M2 has been downgraded as a reliable indicator…. [The] relationship between M2 and prices that could anchor policy over extended periods of time… [has] broken down…. M2 and P-star may reemerge as reliable indicators of income and prices….

In the meantime… in assessing real rates [of interest], the central issue is their relationship to an equilibrium interest rate, specifically the real rate level that, if maintained, would keep the economy at its production potential over time. Rates persisting above that level, history tells us, tend to be associated with slack, disinflation, and economic stagnation–below that level with eventual resource bottlenecks and rising inflation, which ultimately engenders economic contraction. Maintaining the real rate around its equilibrium level should have a stabilizing effect…. The level of the equilibrium real rate… [can] be estimated… [well] enough to be useful for monetary policy…. While the guides we have for policy may have changed recently, our goals have not…

Greenspan thus shifted the focus of America’s macroeconomic discussion away from the level of spending and the quantity of money to the configuration of asset prices. In some ways this is no big deal: “Keynesian”, “Friedmanite”, and “Wicksellian” frameworks are all perfectly-fine ways to think about macroeconomic policy. They are different–some ideas and some factors are much easier to express and focus on and are much more intuitive in one of the frameworks than in the others. But they are not untranslateable–I have not found any point that you can express in one framework that cannot be more-or-less adequately translated into the others.

The point, after all, is to find a macroeconomic policy that will make Say’s Law, false in theory, true enough in practice for government work. You can start this task by focusing your analysis first on either spending, or liquidity, or the slope of the intertemporal price structure. You will almost surely have to dig deeper into the guts of the economy in order to understand why the current emergent macro properties of the system are what they are. But any one of the languages will do as a place to start. Greenspan in the mid-1990s judged that the Wicksellian language provided the best way to communicate. And, looking back over the past 25 years, I cannot really disagree.

But at the time, back in 1994, the shift to a Wicksellian episteme led to substantial confusion. As I remember it, I spent my lunchtime on July 20, 1994, seated at my computer in my office on the third floor of the U.S. Treasury, frantically writing up just what Alan Greenspan was talking about when he said (1) pay no attention to Federal Reserve policy forecasts of M2; instead, (2) pay attention to our assessments of the relationship of interest rates to an equilibrium interest rate. Greenspan announced that the Fed was no longer asking in a Friedmanite mode “do we have the right quantity of money?”, but rather was asking in a Wicksellian mode “do we have the right configuration of interest rates”. And that still does not seem to me to be a bad place to be.