Lately, I’ve been thinking about discount rates and subjective rates of time preference and intergenerational win-win.
Discount rates (in the context of this post) are the rates by which cost benefit and cost effectiveness analysts (CBA/CEA) discount costs and benefits of programs and projects that are realized in future years. They reflect both the erosion of purchasing power (i.e., inflation) and the opportunity costs of an investment that pays off over several (or many) years in the future (i.e., the interest rate or the return on investment that would have been realized had you invested the money elsewhere rather than spending it on a project like, say, a health care clinic or a road or schools). The use of discount rates has the consequence that the further out in the future benefits and costs occur, the less “weight” they receive when they are added over time to obtain their “present value,” i.e., the net value (total benefits minus total costs) of the stream of gains (benefits) and losses (costs) associated with the project over time.
Subjective rates of time preference (SRTP) relate to how individuals subjectively value future gains and losses. It is econ-speak for whether you prefer your money now or later. Someone who would prefer to have $100 today rather than $110 a year from today has a subjective rate of time preference of 10% [($110-$100)/$100=.10 X 100 = 10%)]. You can think of it as economists’ way of measuring or talking about a person’s tolerance for delayed gratification. If you have a high SRTP, you aren’t very good at delaying gratification, you’re not very future-oriented, and you probably don’t worry too much about what your health state will be in 10 years, so you don’t lose weight, stop smoking and cut your alcohol intake to a moderate level. It is the eat-drink-and-be-merry-for-tomorrow-we-may-die syndrome; the grasshoppers in Aesop’s fable. If you have a low SRTP, you are far-sighted with regard to the future. You alter your diet to improve your health 20 years from now, you save money for a rainy day, you’re willing to wait longer for the same payoff as a high SRTP person. You are the ant in Aesop’s fable.
Recent research in behavioral economics suggests that all humans, even people with low SRTP, tend to be fairly myopic (with regard to the time horizon) when making decisions like how much money to save for retirement or whether or not to buy health insurance. This is called hyperbolic discounting. It means that the weight or value we place on future gains and losses drops off steeply at a time that is fairly proximate to the present (say, 2 to 3 years). For this reason, things that are likely to yield gains or payoffs farther out in time, like something you could do now to improve your well-being in 10 or 20 years, don’t have much influence on decisions that we make today whereas more proximate (in time) gains or payoffs do. So we prefer to keep smoking rather than to stop smoking. We prefer to eat dessert rather than to lose weight. We prefer to consume more now and rather than later. This is one of the “animal spirits” that Keynes originally alluded to and that has been described recently by George Akerlof and Robert Shiller.
SRTP is a subjective way that we discount future gains and losses. It tends to “tilt” the world in favor of the present. The discounting used in CBA and CEA tends to reinforce this “present” orientation. Projects and public policies that yield benefits or costs sooner are valued over those whose benefits and costs are realized later.
So we “borrow” from our grandchildren and their grandchildren to finance things that we prefer today. We rationalize it by using methods like cost benefit analysis and costs effectiveness analysis that employ discount rates that effectively down weight future gains and losses. And we prefer to do this because we would prefer to gain today rather than tomorrow.
Don’t get me wrong. There are good reasons for employing discount rates in public policy analysis. It’s just not clear that the folks with the most to gain now are the right ones to be using a tool that is skewed in their favor.
The reason I’ve been thinking about discounting and SRTP is I’ve been wondering how can we rationalize, i.e., make rational, this tendency of ours to borrow from our children and grandchildren to finance our consumption today? Can we figure out ways to do it that not only don’t bankrupt them, but actually provide them with some net benefits? Is there an intergenerational win-win position?
If my grandparents had better nutrition and health care, I would be healthier. So anything my grandparents or the US government spent on those two commodities are intergenerational win-wins. The public monies spent during the 1930s to build National and State Parks are still yielding benefits to outdoors lovers like me: another intergenerational win-win. The national highway system that Eisenhower began in the 1960s is starting to crumble, but it still represents an intergenerational win-win. You, dear reader, think of some other examples.
So when we’re talking about fiscal stimulus packages and we’re borrowing from our grandchildren to finance them, we should be thinking about how to use stimulus monies to create value for those grandchildren AND stimulate our economy. Expanded health insurance now will improve our health and their health and increase their well-being and productivity (wealth). Win-win. Improved infrastructure now will improve our economy and their well-being and productivity. Win-win. An improved environment and green technologies will build new industry now and improve their well-being by improving the climate and the planet on which they dwell. Win-win. Expanded education now improves grandparent well-being and productivity and fosters the intergenerational transfer of human capital. Improved education has also been linked directly to improved health. Win-win.
Intergenerational win-win: It’s how we should have spent the stimulus money. It’s how we should be spending generally. National health insurance, education, environment, infrastructure. We AND our grandchildren would win.