Monday, July 17, 2017

Loss of Control: An Economist's Perspective

Incentives are not aligned

Commitments lose their value when there are too many of them

A previous postings, introduced the idea that previous politicians have severely constrained the options available to currently-elected officials. The first such posting focused just on debt. It was followed by a number of postings on the loss of control implied by other decisions made by previous politicians. One posting addressed the current situation. It was followed by postings on the outlook for programs that constrain currently-elected officials’ ability to set priorities. The postings all focused on describing the situation (70% of all expenditures are mandated) and the outlook (all the mandated categories of expenditures are going to grow, some exponentially).

A logical follow-on question is: so what? Each individual can reach his or her own conclusions about the appropriateness of constraining the options available to currently-elected officials. Similarly, everyone has his or her own opinion about the benefit of the different programs that create the constraints. However, what can't be denied is that the constraints are real, that all indications are that they will grow, and that some of them will grow exponentially if left unmodified.

The US government was set up to put constraints on politicians. The federal system puts constraints on what any level of government can do. Each of the three branches of the federal government constrains the activities of the other branches. Even our legislature was divided into two houses in order to constrain immediate impulses of the popularly-elected lower house while ensuring that popular impulses would be represented. Importantly, the Bill of Rights is quite explicit in constraining government actions. However, there isn't an apparent similar constraint that operates over time. We’re dependent upon responsible action of previous officials as the only assurance that future officials will have enough latitude to govern.

As an economist and financial planner, I'll leave it to philosophers and political scientists to address whether there are adequate protections in the structure of our government. What is clear is that something will have to be done. Exponential growth is never sustainable. Policy wonks and politicians will undoubtedly put tremendous effort into trying to figure out what to do about the situation we've gotten ourselves into. Economic and financial planning considerations are not irrelevant.

One of the advantages of approaching it from an economics perspective is the immediate realization that there is no good or bad associated with the commitment to future liabilities. Economists have dealt with analogous issues for ages. They use a concept referred to as time preference. Early on it was illustrated by references to the decision to keep part of the harvest as a seed crop versus consuming it. Over time, economics has become much more sophisticated to the point where today behavioral economists working with neurologists can literally identify the areas of the brain involved in making decisions that involve time preference. From that they can imply, or speculate about, how the decisions are being made.

One of the places where economists and financial planners have a supposedly sophisticated approach to time preference is in financial planning. It is usually referred to in the context of the time preference for money. It can be handled by employing a concept known as the risk-free rate of return.

Usually the rate of return on government debt is used as a proxy for the risk-free rate of return. As is argued in an April 1, 2010 posting entitled“Beware the Risk-Free Return,” the very concept of the risk-free rate of return is seldom appropriate. It is particularly inappropriate in this context. As the posting states; “Sovereign entities are not too big to fail. Default isn’t an absolute. There are a lot of ways sovereign risk can be expressed. Rates are one.”

The risk-free rate of return falls apart when addressing issues related to the constraints previous politicians have placed on the US. It uses a variable (a Treasury rate) that is influenced by the constraints and, in turn, feeds back to raise the constraints. To illustrate, one of the concerns is that the interest burden from the debt and other mandated expenditures will cause interest rates to rise. Those higher interest rates will, in turn, exacerbate the debt service burden causing it to grow exponentially.

Conceptually, when dealing with policy issues, the equivalent of the risk-free rate of return would be what might be called the social-rate of return on expenditures. The social-rate of return on expenditures is a useful concept even if it can't be measured directly. It can be used to compare the incentives of different participants in a social-policy decision process. Whether there is misalignment between the incentives to make future commitments and the return on those commitments is a legitimate question.

It makes sense for politicians to commit to future expenditures if the return on the expenditures can confidently be forecast to be greater than the cost. That begs the question of why the politicians should be allowed to commit to future expenditures since, if the return on expenditures will be greater than their cost, future politicians will make the expenditure. Further, by making a commitment based upon a belief that in the future expenditures will be justified, politicians are introducing additional risk. They are introducing the risk that they are wrong in their forecast of future returns on those expenditures. Given those two facts, it's hard to see how to justify the current level of commitments. It suggests that a misalignment of incentives may exist.

However, before reaching that conclusion, one needs to consider another justification for the commitments. That justification is that there is a social return to the commitment itself. The best example familiar to anyone in finance is the low interest rate paid by nations that have a long history of, and thus implied strong commitment to, meeting their sovereign obligations.

It isn't just financial markets where future commitments have value. Theoretically, citizens and businesses benefit from knowing that the government has made a certain commitment. For example, the commitment to Social Security and Medicare is an input into retirement planning. The burden of financial planning for retirement is lightened to the extent one can count on those programs. A commitment to certain rights of property benefits both individuals and the economy in general. Neither individuals nor businesses can plan if they don't know what they own and what ownership implies.

The value of the commitment depends upon two things: (1) The degree to which there is confidence in the commitment, and (2) the nature of the expenditures that are being promised.  The nature of the expenditure that results in a commitment has to be addressed individually for each expenditure. Further, it is very dependent on personal preferences regarding the expenditure. Therefore, it is more fruitful to address how the value of commitment relates to the degree of confidence one can put in the commitment.

For shorthand, one can refer to how the value of the commitment relates to the degree of confidence in the commitment as simply the value of the commitment. The value of a commitment isn’t constant. For example, the April 1, 2010 posting pointed out evidence that, at that time, investors were placing more confidence in certain corporate debt than they were in Treasury debt. Similarly, surveys currently indicate many younger Americans have no confidence that they will receive Social Security benefits. So, there is ample evidence that politicians have made commitments to future expenditures far beyond the point of diminishing returns.

The value of the future commitment is discounted based upon the risk that the commitment will not be met. That risk rises the more commitments there are. In the US, the magnitude and nature of the commitments has reached the point where there are so many commitments that they are all being discounted at a steeper rate than historically. Historically, the first commitment required less of the budget, and therefore was easier to meet. Plus, that commitment didn't have to compete with other commitments made by the government.

Commitments have value even if they are steeply discounted. Economists have techniques for handling situations where costs increase while returns are falling. However, those techniques assume that the costs and returns both affected the same entity. That assumption is inappropriate for government expenditures especially when the commitments are across multiple generations. The costs may be borne by a group totally different from the one that receives the benefits.

It isn't just the distributional issue. The dilemma is that both the costs and returns to the commitments are different from a social perspective versus a political perspective. From a political perspective, as long as the commitment has any value, there is an incentive to make the commitment. The costs are not born by the current politician. By contrast, from a social perspective, the commitment must have value that exceeds the future cost. So, it is highly likely that there are many commitments that have political value that far exceed their value to society. To some extent, that explains why such a large portion of future tax revenue has been committed by previous politicians.

However, it would be very convenient to simply blame politicians. Given the population’s current low regard for politicians as indicated by the polls, it's an easy out.  Unfortunately, the problem is much more serious. Politicians may just be responding to legitimate choices being made by the electorate.

If the value of commitments to expenditures in the future has dropped because of heightened risk that the commitments won’t be honored, one would expect it to be necessary for politicians to make increasingly large commitments to future expenditures. To illustrate, if one gets a commitment for $10,000 and is sure it will be received, it is considered to be worth $10,000 at that future date. If one believes there's only about a 10% chance that the future commitment will be met, the commitment has to be for $100,000 to have the same value of $10,000 at that future date.

A second response would be for politicians to reduce the time horizon over which the value of the commitment is discounted due to risk the commitment will not be met. In other words, politicians have an incentive to make the commitment so immediate that the risk that future politicians wouldn't meet it is irrelevant.

Both affects would encourage politicians to make commitments to mandated expenditures that are immediate and large. In essence, the incentive is to make commitments that have immediate expenditure consequences but delayed cost consequences. By degrading the value of governmental commitments to expenditures, the debt becomes the preferred to option.

To summarize, there is a misalignment of incentives that encourages over-commitment to mandated programs. Over-commitment decreases the value of the commitments by increasing the risk that they won't be met. That shortens the potential time horizon for such commitments and encourages debt financing of those commitments. 

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