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December 30, 2008

Public policy and discount rates

I read Cowen's recent Op-Ed Bailout of Long-Term Capital: A Bad Precedent? and it caused me to muse upon Keynes' quip that in the long run we are all dead. His quip has been used to argue that moral hazard is less important than somehow getting a handle on panic in the current financial calamity. Cowen says:

As we look ahead, we may be tempted again to put off the hard choices. But perhaps the next "long run," too, is no more than 10 years away. If we take the Keynesian maxim too seriously, and focus only on the short run, our prospects will be grim indeed.

Arguing for a public policy on the basis that in the long run we are all dead is an argument for a high discount rate and a high elasticity of inter-temporal substitution. That is, since we'll all be dead, lets make sure that we fix things for today, regardless of what that does to things some time down the road. What I find interesting about this is that that is exactly the opposite take of left of center policy folks when dealing with environmental policy issues. In order to justify extensive government response to global warming, the Stern Report had to use discount rates near zero, that is to assume that the future is just as important as today and in the long run we'll either still be there or others will and we value their happiness as much as out own.

The more you care about the future the more you should care about the moral hazard created by government entry into the financial industry. The more you care about the future the more you should worry about the potential consequences of climate change.

Of course it could be that the costs of climate change are so high and those of moral hazard so low that the same discount factor would justify both policy interventions. It just seems that given the difference in language we hear in the two policy discussions, it seems different rates are being used to assess the two policies and the outcomes could well be different if a harmonious rate were used in both analyses.

Posted by OneEyedMan at December 30, 2008 9:13 AM

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