Waccy Economics: Are There Clear Rules Governing Public Investment?

Listener: 6 September. 2003.

Keywords: Business & Finance;

Not learning from the past often results in repeating its mistakes. So a short history of “project evaluation” is called for. In the 1950s, overseas economists proposed Cost-Benefit Analysis (CBA) as a systematic way of appraising government investment. By the late 1960s, it was being applied in New Zealand, but various government departments applied it differently.

The most contentious parameter was the “discount rate”, a measure of the community choice between today and the future. If the discount rate was 10 percent a year (above the rate of inflation), the community would want a return of at least $200 in seven years’ time for an outlay of $100 today. Projects that only returned $150 from the $100 would be rejected. The discount rate reflects the trade-off between consuming today rather than investing for consuming tomorrow.

Suppose that one government department had a discount rate of 12 percent pa, while another had one of 6 percent pa (such disjunctions were not untypical in the 1960s). The first department would reject a project with a return of 10 percent (it being below its 12 percent pa requirement), while the second would proceed with one with an 8 percent return (since it was above its 6 percent pa threshold). The different thresholds meant that society was not always investing in the most socially profitable projects.

By the 1970s, it was agreed that the same CBA rules and parameters should apply everywhere. What was not agreed were the precise parameters, especially the correct social discount rate. The theoretical debate was heated. With hindsight, it can be seen to be a conflict between the Rogernomes and the pragmatists, with the Rogernomes playing their subsequent game of stating the solution without providing a theoretical underpinning and then using their authority in the Treasury to make everyone else follow them.

The practical debate erupted over “Think Big”: whether various major energy-based projects should go ahead. Did a particular project attain the discount rate? Was its social rate of return high enough? Afterwards, the real issue proved to be risk: what happened if some of the other assumptions – especially the world price of energy – were wrong. They were, and the downsides on the investments were carried by the government, so it was the taxpayer, not the investor, who bore the losses.

To avoid such outcomes, the strategy of the 1980s was to get an economic system where the government did not have to intervene. That “solved” the discount-rate dispute. Businesses made their own decisions about investment. If they got them wrong, their shareholders suffered. If they got them very wrong, so would their bankers, suppliers, workers and customers. In practice, business uses the “weighted average cost of capital” (WACC, pronounced “whack “) as their internal discount rate. Whether social and private discount rates are the same, an issue fought over two decades ago, is now ignored. That is where the debate settled in the 1990s, except CBA is still used in a few non-market sectors such as health and roading.

However, the Treasury had to set a WACC for the state-owned enterprises that the Crown still owns. Typically, it is about 12 percent pa. Meanwhile, the Commerce Commission has to set pricing rules for private monopolies. Their WACC is sometimes as low as 6 percent pa. WACCs vary with risk, so they are an improvement on the discount rate. But the enormous variation is unconvincing. Are we back to the 1960s with different government agencies using markedly different parameters for what appears to be essentially the same exercise?

The result of different WACCs may be that the market signals for pricing and investment are inconsistent. Consider a state-owned enterprise negotiating a joint venture with a private monopoly under Commerce Commission price controls. The former has to get 12 percent pa to please its Treasury masters, but the latter may be restricted to only 6 percent pa. Another paradox was that privatising a state-owned monopoly could reduce its prices, although in the long run it might perform poorly because its low profitability would mean there was insufficient investment.

So the same economic model called the Capital Asset Pricing model (CAPM pronounced “cap-em”) apparently gives different answers to different public agencies – even after using the same consultants. A common view is that CAPM is problematic – while it incorporates some risk, it is not sufficiently comprehensive. But there is no viable alternative. It remains the workhorse for business investment decisions, so everyone understands it – even if only vaguely.

The lesson here is not the circularity of history – although one rather hopes that this decade’s debate will be more pragmatic and theoretically founded than that of the 1970s. Rather, it is hard to have consistent rules when governments intervene, unless there is an overarching framework. I doubt we have one at the moment.