Banking & Finance and Economic Analysis

HICKS: Discounting the future when making public policy

November 20, 2010

Debate about public policy is littered with studies about benefits and costs of alternative public investments.

I personally have published studies on matters ranging from highway, rail and defense expenditures to early-childhood education and walking trails. Many studies find clear benefits—though an equal number find that benefits do not outweigh costs for particular programs. It is not hard to reconcile different studies on the same issue.

What is exceedingly difficult is making comparisons across different activities at different times. The matter that complicates the decision process is shockingly simple in concept—it is how much we value the future relative to the present. In determining what is the best policy, leadership and good judgment matter as much as good technical analysis. Here’s why:

As you will learn in any good high school economics class, everyone values the future less than the present. The antique-sounding term for this is “discounting” the future. Everyone discounts the future at different rates. These rates differ not only for individuals, but also for different activities at different times in their lives. This leads to some surprisingly counterintuitive outcomes.

Young people typically value the future less than older folks, in part because their supply of the future appears greater. As a consequence, they do far more risky things and save less, actually lessening their future options. An example of this comes from the immortal words of my father, who advised me that, “Before I met your mother, I spent 90 percent of my money on women and beer and wasted the other 10 percent.” He is now a respected scientist, married more than 50 years. His discount rate changed.

Public investment is more difficult, since our collective valuation of the future changes with world and economic conditions. On top of that, the future of a public investment is often longer than a human life span, which offers up even more analytical challenges. Here’s an example:

Almost all Americans wish to have available to future generations more transportation options. Such things as high-speed rail and urban transit are prime examples of popular investments. But, those things lie in the distant future. Five years ago, these were popular, but the present offers us a world at war, a country with 10-percent unemployment, and a scary deficit. So, the value of a future with these things declines relative to the present without more immediate spending priorities (like unemployment compensation or debt reduction).

A similar problem occurs with such things as spending to prevent global warning. Efforts to reduce carbon emissions are intended to mitigate the ills of an uncertain and potentially distant future. Complicating the choices is the fact that the costs of addressing global warming will be borne by people now, who are poorer and possess fewer technological options than people living 50 years from now. We discount this future more highly relative to the present. Understanding the factors that cause us to discount the future is a key to good policy judgment.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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