Once upon a time, canals were the latest thing in infrastructure investment. During the early years of the Industrial Revolution, they made it possible to move heavy goods, like coal, from mines to factories, using a fraction of the energy required by road transport. Delicate goods, like pottery, could be shipped with little breakage. Enterprising engineers and industrialists built canals in all sorts of unlikely places. There is even a canal system that crosses from England into the Welsh mountains, complete with the towering Pontcysyllte Aqueduct, which allows canal boats to traverse the Dee valley.
I visited Pontycysyllte this summer. When I showed Nick Rowe my holiday pictures and told him about the canal, his first reaction was “this is an argument for discounting future returns”
Why? The Pontcysyllte Aqueduct opened in 1805. Within 40 years, it was becoming obsolete, as railways began to supersede canals. Pontcysyllte exemplifies the fact that investment is an uncertain business. Any kind of technological or other kind of shock can cause the returns to infrastructure investment to evaporate.
For example, suppose I build a canal, expecting to generate, if current economic trends continue, a return of $5 million per year indefinitely. What if, every year, there is a one percent chance that a technological revolution will cause the canal's future profits to fall from $5 million per year to zero? The amount that the investor can expect to receive from the canal in year t then becomes 0.99t*$5 million – the compounded effects of there being, in every year, only a 99 percent chance that the canal will continue to be useful. In a picture:
The expected returns shown in the picture above are not the result of a traditional net-present-value calculation. Even a person who is indifferent between receiving $1 now and $1 in the future must realize that the future is uncertain, and factor that uncertainty into his or her investment calculations – not by discounting the future, but rather by recognizing uncertainty when estimating the future benefits and costs of their investments.
My reaction to the Pontcysyllte Aqueduct was very different from Nick’s. I thought: “this is an argument against discounting.” Why? Today, the Pontcysyllte Aqueduct is a lynchpin of the local economy. The tourists it attracts are one reason why the nearby town of Llangollen is thriving. The benefits that Pontcysyllte is generating now, more than 200 years after it opened, matter.
Discounting means that far distant costs and benefits are ignored in cost-benefit analyses. For example, using an 8 percent real discount rate – the rate cautiously suggested by the Treasury Board here – a $100 benefit received 200 years in the future is not worth one penny today. Yet when I stood on Pontcysyllte Aqueduct this summer the experience didn’t feel worthless – it meant something to me. What possible justification can there be for ignoring the long-run impacts of our actions? Future lives matter too.
One argument for discounting the happiness of future generations is that they will be so much richer than us that the future costs and benefits of our actions today will not matter to them. Perhaps a real return of $5 million will mean nothing in 200 years’ time. Yet it is also possible that future generations will be poorer than us, and $5 million will mean more to them than it does to us. Indeed, if climate change, resource depletion and population growth have serious negative consequences in the medium to long term, there is a case for using a negative discount rate. That is, if our grandchildren will be significantly worse off than we are now, it's worth sacrificing $100 today to generate benefits of $90 for our grandchildren.
Another argument in favour of discounting is “pure time preference” – the idea that having jam today is preferable than having jam tomorrow. (Until tomorrow comes and you’re hungry and wish you had some jam.)
For understanding individual decision making, the assumption of time preference makes a certain amount of sense. Empirical evidence suggests most people save little of their income for future consumption. Yet from a moral or ethical stand point, it is not clear why the happiness of future generations is of less worth than the happiness of people alive today.
The Stern Review on the Economics of Climate Change made this point quite forcefully:
Thus, while we do allow, for example, for the possibility that, say, a meteorite might obliterate the world, and for the possibility that future generations might be richer (or poorer), we treat the welfare of future generations on a par with our own. It is, of course, possible that people actually do place less value on the welfare of future generations, simply on the grounds that they are more distant in time. But it is hard to see any ethical justification for this. It raises logical difficulties, too. The discussion of the issue of pure time preference has a long and distinguished history in economics, particularly among those economists with a strong interest and involvement in philosophy. It has produced some powerful assertions. Ramsey (1928, p.543) described pure time discounting as ‘ethically indefensible and [arising] merely from the weakness of the imagination’. Pigou (1932, pp 24-25) referred to it as implying that ‘our telescopic faculty is defective’. Harrod (1948, pp 37-40) described it as a ‘human infirmity’ and ‘a polite expression for rapacity and the conquest of reason by passion’.
The Stern Review’s argument, in a picture:
The final justification for discounting the future returns from investment is the opportunity cost of capital. The funds required to build, say, an aqueduct must come either from foreign or from domestic savings. Any domestic savings used to finance an aqueduct represents money that could have been used for something else, either consumption, or other domestic investment. The opportunity cost of building an aqueduct is the returns the money could have earned elsewhere – and if the aqueduct does not generate returns at least as great as those available elsewhere in the economy, it is not worth building.
Jenkins and Kuo set out the opportunity cost argument for discounting here. Using data on the real returns to Canadian domestic investment from 1966 to 2005, as well as estimates of individuals' rates of time preference and the cost of foreign borrowing, they conclude, “The results suggest that estimates of the economic discount rate can range from 7.78 percent to 8.39 percent real”. Drawing in part from Jenkins and Kuo’s work, the Canadian Treasury Board Secretariat's 2007 Guidelines for Cost Benefit Analysis suggested the use of an 8 percent real discount rate. While this might seem high given current yields, it was actually significantly lower than the ten percent real rate of discount recommended by the Treasury Board in 1998.
The valuation of future benefits and costs is critical in any kind of long-term decision making, especially for deciding how much to invest to prevent or ameliorate the impacts of climate change. Consider, for example, an investment in preventing climate change that is expected to have some kind of payoff in 50 years’ time. With an 8 percent real discount rate, a $10 investment in a 50-year-time-horizon-project must have an expected payoff of at least $469 ($10*1.08^50) to be worthwhile. I would expect few projects to pass that kind of a test.
Recent government reports which have advocated taking action on climate change have done so on the basis of much lower real discount rates than the ones the Treasury Board recommended back in 2007. For example, a March 2016 Technical Update to Environment and Climate Change Canada's Social Cost of Greenhouse Gas Estimates had this to say on the choice of discount rate:
….there is no consensus position in the literature on the “correct” discount rate to use. Some advocate discount rates based on observed market rates of return. Others argue that it is unethical to value costs to future generations less than those to current generations.
The U.S. Group selected three different discount rates to reflect varying views in the economic literature (2.5%, 3% and 5%). The central rate at 3% is recommended by the U.S. Office of Management and Budget when a regulation primarily affects private consumption.
And then:
The Canadian Group considered how best to adapt the U.S. SCC work for Canada over the course of 2011. While alternative parameters, such as declining discount rates, were discussed, it was ultimately determined that it was more practical to adopt the U.S. results (emphasis added).
For some more background on how those US numbers were calculated, and the thinking behind the choice of discount rate, see here.
The most fundamental public policy choices we face involve trade-offs between current and future consumption: the desirability of tax cuts and deficit finance; the value of reducing greenhouse gas emissions; the advisability of investing in infrastructure. If you want to know an economist’s views on things that matter, forget about minimum wages or free trade. The most important question of all is “what is the social discount rate”? The moral argument for discounting the well-being of future generations has always been dubious. The opportunity cost argument might have seemed convincing during the heady days of the tech boom. But now that negative interest rates are a serious possibility, even the opportunity cost of capital argument for discounting seems questionable.
Worthwhile Canadian Initiative 
Things of beauty and which inspire us belong in museums and galleries.
A painter of houses does not need to be able to reproduce the Mona Lisa.
A capitalist of the 19th century did not need the calculus of modern financial theory to decide whether to build a system of aqueducts and canals. As I suggested above, he was probably more interested in whether the water would continue to fill his waterways.
Henry,
“Things of beauty and which inspire us belong in museums and galleries.” That’s ignorant anti-intellectual nonsense.
Modern economics helps us understand optimal decision making. The 19th century decision makers didn’t require modern models to decided what to do. Our modern models explain why they made the decisions they did.
Think Poker. Poker is an economics problem masquerading as a game. Solving this problem is an incredibly complicated dynamic program – the same methods used in economics. Now, most good Poker players know little about dynamic programming or the approximate dynamic programming methods used to solve the game out to finite horizons. But, good Poker players BEHAVE as though they do know how to solve these complicated math problem. Through hard-won experience and a good memory good Poker players build mental heuristics that come close to the actual mathematical solution. The same thing happens with investing. Of course few investors, 19th century or otherwise, solving dynamic programming problems, computing Gittins indices, or solving shortest path problems to optimality, but their collective behaviour is like the Poker player – they largely behave as though they are solving these hard math problems. That insight allows us to ask deeper questions and understand the underlying structure of the problem that investors are solving.
A great practical example of this type of thinking involves discounting. In the 1980s, the US government introduced rebates for high grade residential insulation to help reduce energy costs for homeowners. Based on a simple discount model, the US government set a rebate policy. To their surprise, the program was really unpopular – few people/builders used the program. Later, proper economic analysis showed that there is a large option value in the decision because the decision is irreversible and energy prices are highly volatile. When you include the value sitting in the option, you can see that people were making optimal decisions in not participating in the rebate – the rebate was peanuts compared to the value of the option. Even though people didn’t solve complicated dynamic programs at the kitchen table, they largely behaved as if they did.
Frank,
“Bankruptcy costs are paid by the debt holders. In the real world, the benefit of the tax deductibility of debt is partially offset by the bankruptcy costs that debt holders have to pay.”
The tax deductibility of debt is a benefit to the debt seller (firm). It stands to reason that the bankruptcy costs (referenced in MM) are those that are seen by the debt seller (firm) as well. Benefit for the firm (tax deductibility of interest) is partially offset by cost to the firm (transfer of assets during bankruptcy).
Frank
The tax deductible interest payments lowers the cost of capital to the firm by lowering the effective interest rate. But the anticipated bankruptcy costs in the event of bankruptcy means that the lenders will demand a higher interest rate as compensation, which raises the firm’s cost of capital. That’s the partial offset.
“Our modern models explain why they made the decisions they did. ”
AB,
There is good deal of assertion making and circularity in your argument in this post.
Henry
Glad to see you’re one of the smartest people on the planet. Make sure to publish your insights on economics somewhere – it’d be a shame if humanity doesn’t get to learn from it.
Avon,
http://www.investopedia.com/walkthrough/corporate-finance/5/capital-structure/bankruptcy-optimal-structure.aspx
“For each company there is an optimal capital structure, including a percentage of debt and equity, and a balance between the tax benefits of the debt and the equity. As a company continues to increase its debt over the amount stated by the optimal capital structure, the cost to finance the debt becomes higher as the debt is now riskier to the lender.”
The risk of bankruptcy increases with the increased debt load. Since the cost (to the firm) of debt becomes higher, the WACC (Weighted Average Cost of Capital) is thus affected. With the addition of debt, the WACC will at first fall as the benefits are realized, but once the optimal capital structure is reached and then surpassed, the increased debt load will then cause the WACC to increase significantly.”
Notice that the bankruptcy costs (discussed in this article) are those realized BY THE FIRM (higher interest costs once the debt load exceeds what is considered it’s optimal debt load).
Or if you prefer:
Click to access cfmsc-chapter-1.pdf
Page 26 of 34:
Bankruptcy costs
Debt might have an important disadvantage:
1. High debt levels increase the chance of financial distress
This is only important if bankruptcy a§ects revenues or costs Direct costs:
2. Legal process of restructuring (court costs, advisory fees) on average 2-3% of the assets (these are legal fees paid by the firm, not bondholders)
Examples:
Enron $30 million per month, $750 million in total
Worldcom (reorganisation to become MCI) $657 million
United Airlines, 8.6 million per month for legal and professional services related to chapter 11 reorganization
Indirect costs:
1. Loss of customers
Bankruptcy may enable firms to walk away from future commitments (support, future upgrades,. . . )
2. Loss of suppliers:
Bankruptcy may enable firms not to pay for inventory Swissair forced to shut because suppliers refuse to fuel planes
3. Loss of employees:
Fear of job security
4. Loss of receivables:
Debtors might have an opportunity to avoid obligations
5. Fire sales of assets:
Companies need to sell assets quickly to raise cash
Again, all costs realized by the firm (not bondholders).
Finally,
Click to access wp139.pdf
Page 8 of 14
To elucidate this point, consider the MM theorem about the irrelevance of capital structure. It states that the amount and structure of debt taken up by a company do not affect its value if: 1) There are no taxes
2) Bankruptcy does not entail any real liquidation costs FOR THE COMPANY nor any reputation costs for its directors
3) Financial markets are perfect, that is, are competitive, frictionless and free of any informational asymmetry
Do you need more sources?
Frank,
Creditors seek compensation for the extra costs that they will bear in the event of bankruptcy. This compensation comes in the form of higher interest rates which increases the firm’s cost of capital. If I lend to a corporation, I know I could lose in case of bankruptcy, that’s why I demand more than the riskless rate. But if I also know that at bankruptcy part of the residual of the firm will be disapated, I need extra compensation in the form of a higher interest rate. The firm’s cost of capital increases.
MM supposes that these costs are absent and that the interest rate only reflects the real risks in the opportunities, i.e., the price of every Arrow security in the firm is the price of risk to hold that component of the risk to which the Arrow security is exposed and nothing else. The firm is free to repackage the risk anyway it likes but it doesn’t affect the firm’s value.
That every corporation has an optimal financing structure is a statement of how MM fails to hold in the real world. In the real world the value of the firm does depend on how it splits the risk. It’s different for every corporation and industry. By tracing through how MM is violated in each circumstance leads to insight into how the firm will make financing decisions.
Now one of us works with these ideas as a professional. Can you guess who?
https://en.wikipedia.org/wiki/Avon_Barksdale
Definitely not you.
“Glad to see you’re one of the smartest people on the planet. Make sure to publish your insights on economics somewhere – it’d be a shame if humanity doesn’t get to learn from it.”
AB,
Nothing less than a Nobel Prize in Economics ( or whatever they call it) will satisfy.
Might even put in a word for you.
Avon,
I went back and looked at the source:
Miller Modigliani, 1958
“The Cost of Capital, Corporation Finance, and the Theory of Investment”
Click to access 48.3.261-297.pdf
Footnote 17 (page 273)
“We conjecture that the curve of bond yields as a function of leverage will turn out to be a non-linear one in contrast to the linear function of leverage developed for common shares. However, we would also expect that the rate of increase in the yield on new issues would not be substantial in practice. This relatively slow rise would reflect the fact that interest rate increases by themselves can never be completely satisfactory to creditors as compensation for their increased risk. Such increases may simply serve to raise r so high relative to p that they become self-defeating by giving rise to a situation in which even normal fluctuations in earnings may force the company into bankruptcy. The difficulty of borrowing more, therefore, tends to show up in the usual case not so much in higher interest rates as in the form of increasingly stringent restrictions imposed on the company’s management and finances by the creditors, and ultimately in a complete inability to obtain new borrowed funds, at least from the institutional investors who normally set the standards in the market for bonds.”
And so your statement:
“Creditors seek compensation for the extra costs that they will bear in the event of bankruptcy.”
This is true to a point. However, MM acknowledges that interest alone may not fully compensate a lender when the interest rate (r) is too high relative to the firms capitalization rate (p). In this case the cost is fully born by the firm – lost access to credit markets.