Can we agree that…(more on fiscal policy, and hurdle rates)

Ryan Avent puts forward some propositions on fiscal policy that he hopes we can agree on (I agree with most of them, dissenting on the multiplier discussion by wanting explicit time horizon considerations, the overall importance given by multiple mentions of ZLB, and being confused but not disagreeing with the wording of the first part of #13).  And in general I am supportive of such attempts to find common ground.

I wish, however, to add to the list.  I wish to nominate a few more items, noting that this does not exhaust my wish list.  Here goes:

1. Debt-financed government spending must eventually be paid off and the estimated deadweight loss of taxation is at least twenty percent.  That immediately puts a hurdle rate of twenty percent or more on projects, even when real borrowing rates are very low.

2. Private companies, when making investment decisions, often use hurdle rates as high as twenty or thirty percent, even when their cost of capital is much lower.  Often it is believed this is to constrain overeager empire builders, or “cowboys.”  For sure, the agency problems in the public sector differ considerably from those in the private sector, but arguably there should be a “cowboy premium” for the public sector as well, even if that premium should be lower for the public sector.

3. The real risk of public sector investment is not measured by the borrowing rate, but rather by the covariance of the value of public sector outputs with a very broad notion of the market portfolio.  I call this the Jensen premium, since Michael Jensen first outlined this argument clearly.

This is all standard stuff, none of it is like reading the “he said, she said” debates over the proper size of the fiscal policy multiplier.

To do some adding up, we have twenty percent plus the cowboy premium plus the Jensen premium.  Plus of course the real time preference rate, if that should be positive too.  It is hard to get a good sense of the size of the cowboy and Jensen premia but still we are running clearly over twenty percent, perhaps a good deal over twenty percent.

I also believe (more controversially, this point is not consensus) that the cowboy premium is considerably higher for debt-financed expenditures, relative to balanced budget expenditures.

Now let’s come to my complaint (which is not directed against Ryan).  I have read dozens — or is it now hundreds? — of blog posts arguing that low borrowing rates make for a very strong case for fiscal policy.  I do not often if ever see these posts admit that the hurdle rate for government investment still can be quite high and still is likely quite high.  I do not see these posts discussing the DWL of taxation, the cowboy effect, or the Jensen effect.  I see only the mention of a very low borrowing rate.

Of course you should adjust the social costs of the project downward to the extent it is mobilizing specific unemployed physical resources (which is quite distinct from the existence of a low borrowing rate per se; for one thing, it is easy to have projects which reshuffle resources and a low borrowing rate, plus the crowding out may come on the labor side).   I see this point about unemployed resources mentioned many, many times, though not with the proper caveats, and I see the points about hurdle rates hardly mentioned at all.  And note by the way that the DWL of taxation premium should be applied to all upfront pecuniary costs, whether or not they are true social costs.

Addendum: Brad DeLong comments.  His #1, if I understand it properly, confuses “spending at all” with “taxing vs. borrowing” calculations.  #2 ignores agency problems and #3 assumes a rather definite view on the understanding of risk.  You will note that my post is quite agnostic on the size of #2 and #3 in any case.


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